---

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549

# F O R M  20   F

|o | REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE
ACT OF 1934
|- | ----------------------------------------------------------------------------------------------

OR

|x | ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF           1934
|- | ----------------------------------------------------------------------------------------------

For
the fiscal year ended December 31, 2006

OR

|o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
|- | ----------------------------------------------------------------------------------------

OR

|o | SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
|- | -------------------------------------------------------------------------------------------

Date of event requiring this shell
company report......................

For the transition period
from ________ to ________

Commission file number:
005-52583



BLUEPHOENIX SOLUTIONS
LTD. (Exact Name of
Registrant as Specified in Its Charter)

Israel (Jurisdiction of
Incorporation or Organization)

8 Maskit Street,
Herzlia 46120, Israel (Address of Principal
Executive Offices)

Securities registered or to be registered pursuant to Section 12(b) of the Act:Ordinary shares, NIS 0.01 par value

Securities registered or to be registered pursuant to Section 12(g) of the Act:None(Title of Class)

Securities for
which there is a reporting obligation pursuant to Section 15(d) of the Act:Ordinary shares, NIS 0.01 par value(Title of Class)

Indicate the number of outstanding
shares of each of the issuers classes of capital or common stock as of December 31,
2006:

14,298,358 Ordinary
shares, NIS 0.01 per share

Indicate by check mark if the
registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o No x



---

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If this report is an annual or
transition report, indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Yes o No x

Note  Checking the box above
will not relieve any registrant required to file reports pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934 from their obligations under those Sections.

Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

Yes x No o

Indicated by check mark whether the
registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
See definition of accelerated filer in Rule 12b-2 of the Exchange Act. (Check
one):

Large accelerated filer o   Accelerated filer o   Non-accelerated filer x

Indicate by check mark which
financial statement item the registrant has elected to follow.

Item 17 o Item 18 x

If this is an annual report, indicate
by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).

Yes o No x

ii

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# TABLE OF CONTENTS

|                                                               |   
|-------------------------------------------------------------- | --
|
|
|
|
|P A R T  I                                                     | 1 
|ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT, AND ADVISERS | 2 
|ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE                | 2 
|ITEM 3. KEY INFORMATION                                        | 2 
|A.    Selected Financial Data                                  | 2 
|B.    Capitalization and Indebtedness                          | 3 
|C.    Reasons for the Offer and Use of Proceeds                | 3 
|D.    Risk Factors                                             | 4 
|ITEM 4. INFORMATION ON THE COMPANY                             | 17
|A.    History and Development of the Company-                  | 17
|B.    Business Overview                                        | 18
|C.    Organizational Structure                                 | 35
|D.    Property, Plants and Equipment                           | 35
|ITEM 4A. UNRESOLVED STAFF COMMENTS                             | 36
|ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS           | 37
|A.    Operating Results                                        | 44
|B.    Liquidity and Capital Resources                          | 49
|C.    Research and Development, Patents and Licenses           | 54
|D.    Trend Information                                        | 54
|E.    Off-Balance Sheet Arrangements                           | 55
|F.    Tabular Disclosure of Contractual Obligations            | 55
|G.    Safe Harbor                                              | 55
|ITEM 6. DIRECTORS, SENIOR MANAGEMENT, AND EMPLOYEES            | 55
|A.    Directors and Senior Management                          | 55
|B.    Compensation                                             | 58
|C.    Board Practices                                          | 58
|D.    Employees                                                | 65
|E.    Share Ownership                                          | 66
|ITEM 7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS      | 68
|A.    Major Shareholders                                       | 68
|B.    Related Party Transactions                               | 69
|C.    Interests of Expert and Counsel                          | 73
|ITEM 8. FINANCIAL INFORMATION                                  | 73
|A.    Consolidated Statements and Other Financial Information  | 73
|B.    Significant Changes                                      | 74
|ITEM 9. THE OFFER AND LISTING                                  | 74
|A.    Offer and Listing Details                                | 74
|B.    Plan of Distribution                                     | 75
|C.    Markets                                                  | 75
|D.    Selling Shareholders                                     | 76
|E.    Dilution                                                 | 76
|F.    Expenses of the Issue                                    | 76
|ITEM 10. ADDITIONAL INFORMATION                                | 76
|A.    Share Capital                                            | 76
|B.    Memorandum and Articles of Association                   | 76
|C.    Material Contracts                                       | 79
|D.    Exchange Controls                                        | 80
|E.    Taxation                                                 | 80
|F.    Dividend and Paying Agents                               | 88
|G.    Statement by Experts                                     | 88
|H.    Documents on Display                                     | 88
|I.    Subsidiary Information                                   | 88

iii

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|ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                   | 89
|------------------------------------------------------------------------------------- | --
|ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES                       | 89
|P A R T  II                                                                           | 90
|ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES                              | 90
|ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS | 90
|ITEM 15. CONTROLS AND PROCEDURES                                                      | 90
|ITEM 16A. AUDIT COMMITTEE FINANCIAL EXPERT                                            | 90
|ITEM 16B. CODE OF ETHICS                                                              | 91
|ITEM 16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES                                      | 91
|ITEM 16D. EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES                  | 92
|ITEM 16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS      | 92
|P A R T  III                                                                          | 92
|ITEM 17. FINANCIAL STATEMENTS                                                         | 92
|ITEM 18. FINANCIAL STATEMENTS                                                         | 92
|ITEM 19. EXHIBITS                                                                     | 92

iv

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# P A R T  I

---

Some
of the statements in this annual report, including those in the Risk Factors, Operating
and Financial Review and Prospects, and Business Overview sections, are forward-looking
statements that involve risks and uncertainties. These forward-looking statements include
statements about our plans, objectives, strategies, expectations, intentions, future
financial performance, and other statements that are not historical facts. We use words
like anticipates, believes, expects,
future, intends, and similar expressions to mean that the
statement is forward-looking. You should not unduly rely on these forward-looking
statements, which apply only as of the date of this annual report. Our actual results
could differ materially from those anticipated in the forward-looking statements for many
reasons, including the risks described under Risk Factors.

As
used in this annual report, references to we, our,
ours, and us refer to BluePhoenix Solutions Ltd. and its
subsidiaries, unless otherwise indicated. References to BluePhoenix refer to
BluePhoenix Solutions Ltd.

The
name BluePhoenix and the names BluePhoenix IT Discovery, BluePhoenix
LogicMiner, BluePhoenix DBMSMigrator, BluePhoenix PlatformMigrator,
BluePhoenix Rehosting, BluePhoenix LanguageMigrator, BluePhoenix
DataMigrator, BluePhoenix SOA-Ready Enablement (Formerly known as WS4Legacy,)
BluePhoenix FieldEnabler, BluePhoenix StandardsEnabler, BluePhoenix
COBOL/LE-Enabler, BluePhoenix EuroEnabler, BluePhoenix Refactoring
Repository (Nebula- code name), BluePhoenix AppBuilder, and BluePhoenix
Redevelopment appearing in this annual report are trademarks of our company. Other
trademarks in this annual report are owned by their respective holders.

1

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# ITEM 1. IDENTITY OF
DIRECTORS, SENIOR MANAGEMENT, AND ADVISERS

Not applicable.

# ITEM 2. OFFER STATISTICS
AND EXPECTED TIMETABLE

Not applicable.

# ITEM 3. KEY INFORMATION

|A. | Selected
Financial Data
|-- | -----------------------

The
following tables present our consolidated statement of operations and balance sheet data
for the periods and as of the dates indicated. We derived the statement of operations data
for each of the years ended December 31, 2004, 2005 and 2006 and the balance sheet
data as of December 31, 2005 and 2006 from our consolidated financial statements included
in Item 18 of this annual report, which have been prepared in accordance with generally
accepted accounting principles as applied in the United States, or U.S. GAAP. Our
consolidated financial statements have been audited byZiv Haft registered public
accountant (Isr.) BDO member firm. The selected consolidated financial data as of December
31, 2002, 2003 and 2004 and for the years ended December 31, 2002 and 2003 is derived
from our audited financial statements not included in this annual report, which have been
prepared in accordance with U.S. GAAP. You should read the selected consolidated financial
data set forth below together with our consolidated financial statements included
elsewhere in this annual report. See Item 5. Operating and Financial Review and
Prospects.

2

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|                                                                | Year Ended December 31,
|--------------------------------------------------------------- | -----------------------
|
|
|
|
|Consolidated Statements of Operations Data:                     |                        
|Revenues                                                        |                        
|Cost of revenues                                                |                        
|                                                                |                        
|Gross profit                                                    |                        
|Software development costs                                      |                        
|Selling, general, and administrative expenses                   |                        
|                                                                |                        
|                                                                |                        
|Goodwill impairment, restructuring costs, and                   |                        
|non-recurring expenses                                          |                        
|                                                                |                        
|Operating income (loss)                                         |                        
|Financial income (expenses), net                                |                        
|Gain on realization of shareholdings                            |                        
|Other income (expenses), net                                    |                        
|                                                                |                        
|Income (loss) before taxes on income                            |                        
|Income tax expense                                              |                        
|                                                                |                        
|                                                                |                        
|Equity in losses of affiliated companies, net                   |                        
|Minority interest                                               |                        
|                                                                |                        
|Net income (loss)                                               |                        
|                                                                |                        
|                                                                |                        
|Basic earning (loss) per share                                  |                        
|Diluted earnings (loss) per share                               |                        
|                                                                |                        
|Weighted average number of shares outstanding                   |                        
|Weighted average number of shares outstanding assuming dilution |                        

|                                 | December 31,
|-------------------------------- | ------------
|
|
|
|
|Consolidated Balance Sheet Data: |             
|Working capital                  |             
|Total assets                     |             
|Total liabilities                |             
|Shareholders' equity             |             

|B. | Capitalization
and Indebtedness
|-- | -------------------------------

Not applicable.

|C. | Reasons
for the Offer and Use of Proceeds
|-- | -----------------------------------------

Not applicable.

3

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|D. | Risk
Factors
|-- | ------------

Our
business, operating results, and financial condition could be seriously harmed due to any
of the following risks. In addition, the trading price of our ordinary shares and
convertible notes could decline due to any of these risks. Additional risks and
uncertainties that we are not aware of or that we currently believe are immaterial may
also adversely affect our business, financial condition, results of operations and our
liquidity.

Risks Related to Our
Business

If capital spending on information
technology, or IT, slows down, our business could be seriously harmed.

We
are affected by global economic changes, in particular trends in capital spending in the
IT sector. During 2001 through 2003, the overall business slowdown in the North American
and European markets influenced the purchasing patterns of leading software developers
who delayed their planned orders and caused developers to reduce the amount of their
planned license commitment. These changes in purchasing patterns in the IT industry
directly affected our operating results. Although we believe that during the last three
years the IT market has begun to recover, we cannot know whether the global market
recovery will continue in the future, and how the economic conditions will continue to
affect our business. Accordingly, we cannot assure you that we will be able to increase
our revenues or keep our revenues at the same level as in 2005 and 2006.

Any future acquisitions of
companies or technologies may distract our management and disrupt our business.

As
part of our growth strategy, we have invested in and acquired control of various
companies to expand our solution portfolio. We intend to continue seeking investment
opportunities. We may incur indebtedness or issue equity securities to pay for these
acquisitions and investments. The issuance of equity securities could dilute our existing
shareholders.

In
addition, as part of our expansion strategy, we increased our controlling interest in some
of our subsidiaries and fully integrated them within our business. We cannot assure you
that we will be able to identify future suitable acquisition or investment candidates or,
if we do identify suitable candidates, that we will be able to make the acquisitions or
investments on commercially acceptable terms or at all. If we acquire, invest in, or
increase our control interest in another company, we could have difficulty assimilating
that companys personnel, operations, technology, or products and service offerings
into our own. In addition, the key personnel of the acquired company may decide not to
work for us. These difficulties could disrupt our ongoing business, distract our
management and employees, increase our expenses, and adversely affect our results of
operations. Acquisitions of new companies, like the recent acquisition of CodeStream
Software Ltd., also involve the risk of penetrating markets in which we have no or limited
experience. For more information about the acquisition of CodeStream, see Item 4.B. Business OverviewInvestments
and AcquisitionsCodeStream.

4

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We have a limited operating
history in our current principal markets, which will make it difficult or impossible for
you to predict our future results of operations.

We
have experienced major fluctuations in our net results. In 2006, we generated $4.7
million net income from our operations. However, in 2002 and 2001 we had a net loss of
$3.6 million and $15.0 million, respectively. The net loss in 2002 and 2001 was a
reversal from prior years in which we had net income. The fluctuations in our net results
are mainly attributable to the changes in the suite of modernization tools we have been
offering to our customers, the limited experience we have had in the markets for these
tools, the capital spending on information technology, and the difficulties we have
encountered in introducing our tools to their respective markets. In addition, global
economic conditions affect our net results. Most of the solutions we offer to our
customers are based on tools that share a common generic technology and methodology.
However, the introduction of new tools to new markets involves increased selling and
marketing expenses, which in turn increases our operating expenses and directly affects
our results of operations. Because of our limited experience in our principal markets and
with our new products, we cannot assure you that our strategy for operating in these
markets or selling these products will be successful. You should not rely on our
historical results of operations as indications of future performance.

If we are unable to accurately
predict and respond to market developments or demands, our business will be adversely
affected.

The
IT modernization business is characterized by rapidly evolving technology and
methodologies. This makes it difficult to predict demand and market acceptance for our
modernization tools and services. In order to succeed, we need to adapt the tools and
services we offer to keep up with technological developments and changes in customer
needs. We cannot guarantee that we will succeed in enhancing our tools and services or
developing or acquiring new modernization tools and services that adequately address
changing technologies and customer requirements. We also cannot assure you that the tools
and services we offer will be accepted by customers. If our tools and services are not
accepted by customers, our future revenues and profitability will be adversely affected.
Changes in technologies, industry standards, the regulatory environment, customer
requirements, and new product introductions by existing or future competitors could render
our existing solutions obsolete and unmarketable, or require us to enhance our current
tools or develop new tools. This may require us to expend significant amounts of money,
time, and other resources to meet the demand. This could strain our personnel and
financial resources.

We may experience significant
fluctuations in our annual and quarterly results, which makes it difficult to make
reliable period-to-period comparisons and may contribute to volatility in the market price
of our ordinary shares and convertible notes.

Our
quarterly and annual results of operations have fluctuated significantly in the past and
we expect them to continue to fluctuate significantly in the future. These fluctuations
are the result of risks related to the introduction of new products as described above and
any of the following events:

5

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| |  | adverse
economic conditions in various geographic areas where our customers and potential
customers operate;
| | - | ------------------------------------------------------------------------------------------------------------

| |  | acquisitions
and dispositions of companies;
| | - | -------------------------------------------

| |  | timing
of completion of specified milestones and delays in implementation;
| | - | --------------------------------------------------------------------------

| |  | timing
of product releases;
| | - | ---------------------------

| |  | timing
of contracts;
| | - | --------------------

| |  | increases
in selling and marketing expenses, as well as other operating expenses; and
| | - | -------------------------------------------------------------------------------------

| |  | currency
fluctuations and financial expenses related to our financial instruments.
| | - | ----------------------------------------------------------------------------------

In
addition, unexpected events that do not occur on a regular basis and that are difficult to
predict may cause fluctuations in our operating results. As a result, we believe that
period-to-period comparisons of our historical results of operations are not necessarily
meaningful and that you should not rely on them as an indication for future performance.
Also, it is possible that our quarterly and annual results of operations may be below the
expectations of public market analysts and investors.

A delay in collection of our fees
could result in cash flow shortages, which in turn may significantly impact our financial
results.

Typical
modernization projects, which deploy our solutions, are long-term projects, and therefore,
payment for these projects or a substantial portion of our fees may be delayed until the
successful completion of specified milestones. In addition, the payment of our fees is
dependent upon customer acceptance of the completed work, and our ability to collect the
fees. Further, although the timing of receipt of our fees varies, we incur the majority of
our expenses on a current basis. As a result, a delay in the collection of our fees could
result in cash flow shortages. To date, we have not experienced any significant payment
delays that resulted in cash flow shortages. Any significant variation in estimated and
actual revenues obtained may significantly impact our financial results in any given
period.

Mainsofts dependency on
Microsoft .NET, an open-source implementation of Microsoft, could have a material adverse
effect on our business.

Mainsofts
Visual MainWin for J2EE has been developed based on the open-source Mono project led by
Novell, which is an open-source implementation of the Microsoft .NET framework. Microsoft
may claim that software developed based on the open-source Mono project infringes certain
Microsoft patents. In addition, Microsoft may cease its business relationship and
cooperation with companies using the open source Mono project, which may result in severe
damage to Mainsofts ability to effectively market the Visual MainWin for J2EE
product.

Damage
to Mainsofts relationship with Microsoft could have a material adverse effect on our
business, financial condition, and results of operations.

6

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If we fail to address the strain
on our resources caused by changes in our company, we will be unable to effectively manage
our business.

In
the past few years, we have undergone significant changes in our product offerings. These
changes include acquiring new technologies, developing and marketing new modernization and
porting tools and expanding the sales of our products further into international markets.
This has placed and will continue to place substantial demands upon our management,
systems, and resources, including our sales, project management, consulting personnel, and
software development operations. Our ability to manage any future changes or growth
depends on our ability to continue to implement and improve our operational, financial,
and management information control and reporting systems on a timely basis, and to expand,
train, motivate, and manage our work force. If we cannot respond effectively to changing
business conditions, our business, financial condition, and results of operations could be
materially adversely affected.

If we are unable to manage the
effects of the variations in our offering portfolio, our results will be adversely
affected.

We
specialize in the development and implementation of sophisticated software modernization
and porting tools and products. We leverage our know-how, experience and generic
technologies, to develop and introduce new software tools that enable the modernization of
legacy systems. The need for our modernization solutions changes over time, and recent
regulations or newly introduced technologies may create new needs for modernization
solutions. As part of our growth strategy, as a new need evolves, we typically conduct a
market analysis to qualify and quantify the market opportunity. If the results justify the
investment required for the development of new products or tools, then we begin the
development process of the new product. In order to maintain our position in the market,
and our ability to address the constantly changing needs of the marketplace, we
continually invest in the development of new products. The net annual expense related to
research and development was $9.4 million in 2006, $8.0 million in 2005 and $8.1 million
in 2004.

In
order to properly introduce a new product to the marketplace or to introduce our current
products into new markets, we continuously update our marketing materials, educate our
sales force and make changes to our operations. If these activities are not completed in a
timely manner, our new product introduction may be delayed and our business, financial
condition, and results of operations could be materially adversely affected.

If we are unable to attract,
train, and retain qualified personnel for our worldwide facilities at competitive prices,
we may not be able to achieve our objectives and our business could be harmed.

In
order to achieve our objectives, we hire from time to time additional qualified software,
administrative, operational, sales, and technical support personnel. The process of
attracting, training, and successfully integrating qualified personnel can be lengthy and
expensive. We may not be able to compete effectively for the personnel we need. As part of
our growth strategy, we developed offshore centers in Cyprus and Romania. We hired
professional consultants for these development centers, leveraging the lower employer
costs that existed in these countries. Recently, professional work in these countries
became more expensive and professional fees may continue to increase in the future. As a
result, we may consider establishing alternative off-shore facilities in other countries.
The establishment of additional off-shore facilities may result in significant capital
expenses which may affect our cash position. We cannot assure you that our off-shore
facilities will be profitable. Our future success depends on our ability to absorb and
retain senior employees and to attract, motivate, and retain highly qualified professional
employees worldwide at competitive prices.

7

---

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If we fail to estimate accurately
the costs of fixed-price contracts, we may incur losses.

We
derive a portion of our revenues from engagements on a fixed-price basis. We price these
commitments upon estimates of future costs. We bear the risk of faulty estimates and cost
overruns in connection with these commitments. Our failure to accurately estimate the
resources required for a fixed-price project, to accurately anticipate potential wage
increases, or to complete our contractual obligations in a manner consistent with the
project plan could materially adversely affect our business, operating results, and
financial condition. In addition, we may agree to a price before the design specifications
are finalized, which could result in a fixed price that is too low, resulting in lower
margins or losses to us.

If our tools or solutions do not
function efficiently, we may incur additional expenses.

In
the course of providing our modernization solutions, the project team conducts testing to
detect the existence of failures, errors and bugs. If our modernization solutions fail to
function efficiently or if errors or bugs are detected in our tools, we might incur
significant expenditures in an attempt to remedy the problem. The consequences of
failures, errors, and bugs could have a material adverse effect on our business, operating
results, and financial condition.

If we fail to satisfy our
customers expectations regarding our solutions, our contracts may be cancelled and
we may be the subject of damages claims.

In
the event that we fail to satisfy our customers expectations from the results of the
implementation of our solutions, or if we fail to timely deliver our solutions to our
customers, these customers may suffer damages. When and if this occurs, customers may have
the ability to cancel our contracts. Any cancellation of a contract could cause us to
suffer damages, since we might not be paid for costs that we incurred in performing
services prior to the date of cancellation. In addition, from time to time we may be
subject to claims as a result of not delivering our products on time or in a satisfactory
manner. Such disputes or others may lead to material damages.

8

---

---



We are exposed to significant
claims for damage caused to our customers information systems.

Some
of the products, tools, and services we provide involve key aspects of our customers
information systems. These systems are frequently critical to our customers
operations. As a result, our customers have a greater sensitivity to failures in these
systems than do customers of other software products generally. We have never been the
subject of a material damages claim related to our modernization solutions or
modernization services. However, if a customers system fails during or following the
provision of modernization solutions or services by us, or if we fail to provide customers
with proper support for our modernization solutions, we are exposed to the risk of a claim
for substantial damages against us, regardless of our responsibility for the failure. We
cannot guarantee that the limitations of liability under our product and service
contracts, if any, would be sufficient to protect us against legal claims. We cannot
assure you that our insurance coverage will be sufficient to cover one or more large
claims, or that the insurer will not disclaim coverage as to any future claim. If we lose
one or more large claims against us that exceed available insurance coverage, it may have
a material adverse effect on our business, operating results, and financial condition. In
addition, the filing of legal claims against us in connection with contract liability may
cause us negative publicity and damage to our reputation.

If third parties assert claims of
infringement against us, we may suffer substantial costs and diversion of
managements attention.

Substantial
litigation over intellectual property rights exists in the software industry. Software
products may be increasingly subject to third-party infringement claims as the
functionality of products in different industry segments overlaps. Although our products
and services have never been the subject of an infringement proceeding, we cannot predict
whether third parties will assert claims of infringement against us. In addition, our
employees and contractors have access to software licensed by us from third parties. A
breach of the nondisclosure undertakings by any of our employees or contractors may lead
to a claim of infringement against us. Any claim, with or without merit, could be
expensive and time-consuming to defend, and would probably divert our managements
attention and resources. In addition, such a claim if submitted may require us to enter
into royalty or licensing agreements to obtain the right to use a necessary product or
component. Such royalty or licensing agreements, if required, may not be available to us
on acceptable terms, if at all.

A
successful claim of product infringement against us and our failure or inability to
license the infringed or similar technology could have a material adverse effect on our
business, financial condition, and results of operations.

We may be unable to adequately
protect our proprietary rights, which may limit our ability to compete effectively.

Our
success and ability to compete are substantially dependent upon our internally developed
technology. Our intellectual property consists of proprietary or confidential information
that is not subject to patent or similar protection. Our employees and contractors have
direct access to our technology. In general, we have relied on a combination of technical
leadership, trade secret, copyright, and trademark law and nondisclosure agreements to
protect our proprietary know-how. Unauthorized third parties may attempt to copy or obtain
and use the technology protected by those rights. Any infringement of our intellectual
property could have a material adverse effect on our business, financial condition, and
results of operations. Policing unauthorized use of our products is difficult and costly,
particularly in countries where the laws may not protect our proprietary rights as fully
as in the United States.

9

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---



Pursuant
to agreements with certain of our customers, we have placed, and in the future may be
required to place, in escrow, the source code of certain of our software. Pursuant to the
escrow arrangements, the software may, under specified circumstances, be made available to
our customers. From time to time, we also provide our software directly to customers.
These factors may increase the likelihood of misappropriation or other misuse of our
software.

We are exposed to litigation that
could result in considerable financial liabilities.

In
July 2003, a former Liraz shareholder filed an application with the Tel-Aviv-Jaffa
District Court to approve a claim filed by him against us, as a class action. The claim
relates to the acquisition of Liraz shares, which we completed in March 2003. The
shareholder alleges that the share price we paid to Lirazs shareholders in the
tender offer and in a subsequent mandatory purchase was lower than the fair price of Liraz
shares. The maximum amount of the claim is approximately NIS 30.5 million ($7.3 million)
in the aggregate. Under Israeli law, the courts approval is required for the
plaintiff to represent all of the shareholders of Liraz who sold their shares to us
pursuant to the tender offer and the mandatory acquisition. The plaintiff has applied for
such approval in the lawsuit. If we are not successful in defending this claim, we could
be exposed to considerable financial liabilities and, as a result, our financial condition
could be materially adversely harmed.

Our largest shareholder, Formula,
controls a majority of our ordinary shares and influences the outcome of matters that
require shareholder approval.

Formula
Systems (1985) Ltd., referred to as Formula, owns, as of March 22, 2007, 52.3% of our
outstanding ordinary shares. Therefore, Formula has the power to control the outcome of
most matters requiring shareholder approval, including the election of directors and
approval of significant corporate transactions. Gad Goldstein, the chairman of our board,
and president and chief executive officer of Formula, directly owns 230,628 ordinary
shares, representing 1.5% of our outstanding ordinary shares. Gad Goldstein owns 2.5% of
the outstanding shares of Formula.

This
share ownership may have the effect of delaying or preventing a change in control.
Although Israeli law imposes certain procedures (including shareholder approval) for
approval of certain related party transactions, including certain of those between us and
Formula, we cannot assure you that these procedures will eliminate the possible
detrimental effects of conflicts of interest. If certain transactions are not approved in
accordance with required procedures under applicable Israeli law, these transactions may
be void or voidable.

Our existing credit facilities
contain a number of restrictions and obligations that limit our operating and financial
flexibility.

Our
credit facilities contain a number of restrictive covenants that limit our operating and
financial flexibility. These covenants, among other things, restrict our ability to pledge
our assets, dispose of assets, make loans or give guarantees, make certain acquisitions
and engage in mergers or consolidations. Our credit facilities also contain covenants
regarding maintaining certain financial ratios. See Item 5.B. Liquidity and Capital
Resources  How We Have Financed Our Business.

10

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Our
ability to continue to comply with these and other obligations depends in part on the
future performance of our business. There can be no assurance that such obligations will
not materially adversely affect our ability to finance our future operations or the manner
in which we operate our business. In particular, any noncompliance with
performance-related covenants and other undertakings of our credit facilities could result
in an acceleration of our outstanding debt under our credit facilities and restrict our
ability to obtain additional funds, which could have a material adverse effect on our
business, financial condition and results of operations.

In
some circumstances, a change of control of BluePhoenix will constitute an event of default
under our credit facilities and we could be required to repay our debts to the banks. If
this occurs, we may not have the financial resources to repay all of our outstanding debt.
This also may adversely affect the attractiveness of our company to potential large
investors.

Our failure to fulfill our
obligations under our credit facility agreements, convertible debentures or other
financial arrangements will adversely affect our cash flow, cash position and net results.

We
intend to fulfill our debt service obligations from existing cash, investments and our
operations. Our failure to fulfill our obligations under our credit facilities, the
convertible debentures or our other financial arrangements, will have significant negative
consequences, including, without limitation:

| |  | requiring
the dedication of a portion of our expected cash flow to service our indebtedness,
thereby reducing the amount of our expected cash flow available for other purposes,
including funding our research and development programs and other capital expenditures;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | increasing
our vulnerability to general adverse economic conditions;
| | - | --------------------------------------------------------------------

| |  | limiting
our ability to obtain additional financing;
| | - | ----------------------------------------------------

| |  | placing
us at a possible competitive disadvantage relative to less leveraged competitors and
competitors                   that have better access to capital resources; and
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | causing
a material offset to our results, resulting decreased net profits or increased net losses.
| | - | --------------------------------------------------------------------------------------------------

# We may not be able to
make our debt payments in the future.

Our
ability to meet our debt obligations will depend on whether we can successfully implement
our strategy, as well as on financial, competitive, and other factors, including some
factors that are beyond our control. Most of our debt and credit facilities bear an
interest rate based on the LIBOR. If the LIBOR materially increases, our cash flows will
be negatively affected. If we are unable to generate sufficient cash flow from operations
to meet principal and interest payments on our debt, we may have to refinance all or part
of our indebtedness. In case we have to increase our indebtedness, the additional
financing expenses will have a negative affect on our results, which cannot be predicted.
Our ability to refinance our indebtedness will depend on, among other things:

| |  | our
financial condition at the time;
| | - | ------------------------------------

11

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| |  | restrictions
in agreements governing our debt; and
| | - | --------------------------------------------------

| |  | other
factors, including market conditions.
| | - | -------------------------------------------

We
cannot ensure that any such refinancing would be possible on terms that we could accept or
that we could obtain additional financing. If refinancing will not be possible or if
additional financing will not be available, we may have to sell our assets under
circumstances that might not yield the highest prices, or default on our debt obligations,
which would permit our noteholders and holders of other outstanding indebtedness to
accelerate their maturity dates. If we incur additional debt or liabilities, our ability
to pay our debt obligations could be adversely affected.

Risks Relating to
International Operations

Marketing our tools and solutions
in international markets may cause increased expenses and greater exposure to risks that
we may not be able to successfully address.

We
intend to continue to expand our international operations, which will require significant
management attention and financial resources. In order to continue to expand worldwide
sales, we need to establish additional marketing and sales operations, hire additional
personnel, and recruit additional resellers internationally. To the extent that we are
unable to do so effectively, our growth is likely to be limited and our business,
operating results and financial condition will be materially adversely affected.

Risks
inherent in our worldwide business activities generally include:

| |  | currency
exchange devaluations;
| | - | -------------------------------

| |  | unexpected
changes in regulatory requirements;
| | - | ----------------------------------------------

| |  | tariffs
and other trade barriers;
| | - | ---------------------------------

| |  | costs
of localizing products for foreign countries;
| | - | ---------------------------------------------------

| |  | lack
of acceptance of localized products.;
| | - | ------------------------------------------

| |  | longer
accounts receivable payment cycles;
| | - | ------------------------------------------

| |  | difficulties
in operations of management;
| | - | -----------------------------------------

| |  | potentially
adverse tax consequences, including restrictions on the repatriation of earnings; and
| | - | -------------------------------------------------------------------------------------------------

| |  | the
burdens of complying with a wide variety of local legislation.
| | - | ------------------------------------------------------------------

We
cannot assure you that these factors will not have a material adverse effect on our future
international sales and, consequently, on our business, operating results and financial
condition.

12

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Inflation, devaluation and
fluctuation of various currencies may adversely affect our results of operations,
liabilities and assets.

We
run our operations in various countries. As a result, we enter into transactions with
customers and suppliers in local currencies. The fluctuations in foreign currency exchange
rates in countries where we operate can adversely affect the reflection of these
activities in our consolidated financial statements. Fluctuations in the value of our
non-dollar revenues, costs and expenses measured in dollars could materially affect our
results of operations. In addition, our balance sheet reflects non-dollar denominated
assets and liabilities, which can be adversely affected by fluctuations in the currency
exchange rates.

The
reporting currency of our consolidated financial statements is the U.S. dollar. The
functional currency of our business is the U.S. dollar. We enter, from time to time, into
forward currency exchange contracts or other arrangements in order to hedge this foreign
currency exposure. Such arrangements may not always be effective or sufficient to offset
the fluctuations in currency exchange rates. For additional information relating to the
exchange rates between different relevant currencies, see Item 5.  Our
Reporting Currency.

Fluctuations in foreign currency
values affect the prices of our products, which in turn may affect our business and
results of operations.

Most
of our worldwide sales are currently denominated in U.S. dollars and euros while our
reporting currency is the dollar. A decrease in the value of the dollar relative to
foreign currencies, in particular the euro, Danish kroner (DKK) and the NIS would make our
products more expensive and increase our operating costs and, therefore, could adversely
affect our results and harm our competitive position in the markets in which we compete.

We are subject to multiple taxing
jurisdictions. If we fail to estimate accurately the amount of income tax due in any of
these jurisdictions, our net income might be affected.

We
operate within multiple taxing jurisdictions and are subject to taxation by these
jurisdictions at various tax rates. In addition, we may be subject to audits in these
jurisdictions. These audits can involve complex issues, which may require an extended
period of time to resolve. We cannot assure you that the final tax outcome of these issues
will not be different than management estimates, which are reflected in our income tax
provisions. Such differences could have a material effect on our income tax provision and
net income in the period in which such outcome occurs.

13

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Risks Relating to
Operations in Israel

Political, economic, and military
conditions in Israel could negatively impact our business.

Over
the past several decades, a number of armed conflicts have occurred between Israel and its
Arab neighbors. Any hostilities involving Israel or the interruption or curtailment of
trade between Israel and its present trading partners could affect our operations. Since
September 2000, there has been a marked increase in violence, civil unrest and hostility,
including armed clashes between the State of Israel and the Palestinian Authority and
other groups in the West Bank and Gaza Strip, and acts of terror have been committed
inside Israel and against Israeli targets in the West Bank and Gaza. During July and
August 2006, major hostilities broke out between Israel and both Palestinian factions in
Gaza and Hezbollah in Lebanon, leading to an escalation of the conflict in the area. Major
towns and settlements in northern Israel, including Haifa, Naharia, Safed and Karmiel,
were under attack from Hezbollah missiles. Such conflicts, as well as the execution of
Israels plan of unilateral disengagement from the Gaza Strip and some parts of the
West Bank and Hamas gaining majority of the Palestinian Parliament in the elections
held in 2006, may affect Israels security, foreign relations and the stability of
the region. Increased hostilities, future armed conflicts, political developments in other
states in the region, or continued or increased terrorism could make it more difficult for
us to conduct our operations in Israel, which could increase our costs and adversely
affect our financial results. In addition, many of our male employees in Israel are
obligated to perform annual military reserve duty typically until 45 years of age and in
some cases up to 54 years of age, and are subject to being called for active duty under
emergency circumstances. While we have operated effectively under these requirements since
our incorporation, we cannot predict the full impact of such conditions on us in the
future, particularly if emergency circumstances occur. If many of our employees are called
for active duty, our operations in Israel and our business may be adversely affected.

It may be difficult to serve process and enforce judgments against our directors and officers in Israel.

We
are organized under the laws of the State of Israel. Most of our executive officers and
directors are  nonresidents of the United States, and a substantial portion of our assets
and the assets of these persons are located outside the United States. Therefore, it may
be difficult to:

| |  | effect
service of process within the United States on us or any of our executive officers or
directors who are nonresidents of the United States;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------

| |  | enforce
court judgments obtained in the United States including those predicated upon the civil
liability provisions of the United States federal securities laws, against us or against
any of our executive officers or directors that are nonresidents of the United States, in
the United States or Israel; and
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | bring
an original action in an Israeli court against us or against any of our executive
officers or directors to enforce liabilities based upon the United States federal
securities laws.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Risks Related to our
Traded Securities

The market price of our
convertible notes and ordinary shares may be volatile and our investors may not be able to
resell the notes or the shares at or above the price they paid, or at all.

During
the past few years, the worldwide stock markets have experienced high price and volume
fluctuations. The market prices of securities of technology companies have been extremely
volatile, and have experienced fluctuations that have often been unrelated or
disproportionate to the operating performance of those companies. These broad market
fluctuations could adversely affect market price of our ordinary shares. The high and low
market price of our ordinary shares traded on the Nasdaq Global Market and the Tel Aviv
Stock Exchange, or the TASE, during each of the last three years, are summarized in the
table below:

14

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| |      | Nasdaq Global Market
In $ | TASE
In NIS
| | ---- | ------------------------- | -----------
|
|
|
|
| | 2006 |                           |            
| | 2005 |                           |            
| | 2004 |                           |            

The
market price of our ordinary shares may continue to fluctuate substantially due to a
variety of factors, including:

| |  | any
actual or anticipated fluctuations in our or our competitors' quarterly revenues and
operating results;
| | - | -----------------------------------------------------------------------------------------------------------

| |  | shortfalls
in our operating results from levels forecast by securities analysts;
| | - | --------------------------------------------------------------------------------

| |  | public
announcements concerning us or our competitors;
| | - | ------------------------------------------------------

| |  | the
introduction or market acceptance of new products or service offerings by us or by our
competitors;
| | - | -------------------------------------------------------------------------------------------------------

| |  | changes
in product pricing policies by us or our competitors;
| | - | -------------------------------------------------------------

| |  | changes
in security analysts' financial estimates;
| | - | --------------------------------------------------

| |  | changes
in accounting principles;
| | - | ---------------------------------

| |  | sales
of our shares by existing shareholders; and
| | - | -------------------------------------------------

| |  | the
loss of any of our key personnel.
| | - | -------------------------------------

In
addition, economic, political, and market conditions and military conflicts and, in
particular, those specifically related to the State of Israel, may affect the market price
of our shares.

In
February 2006, we completed an underwritten public offering in Israel of series A
convertible notes, referred to in this annual report as the convertible notes, in an
aggregate principal amount of NIS 54.0 million that were equal at that time to
approximately $11.5 million. Following the offering, the convertible notes have been
listed for trading on the TASE. The trading price of the convertible notes depends on many
factors, including but not limited to, prevailing interest rates, the trading price of our
ordinary shares, the market for similar securities and general economic conditions.
Therefore, the trading price of the convertible notes could be subject to significant
fluctuations. Additionally, it is possible that the market for the convertible notes will
be subject to disruptions that may have a negative effect on the holders of the
convertible notes, regardless of our prospects or financial performance. During 2006, the
market price of our convertible notes traded on the TASE, fluctuated between NIS 1.06 and
NIS 1.02.

Our ordinary shares are traded on
more than one market and this may result in price variations.

Our
ordinary shares trade on the NASDAQ Global Market and the TASE. Trading in our ordinary
shares on these markets take place in different currencies (dollars on the NASDAQ Global
Market and NIS on the TASE), and at different times (resulting from different time zones,
different trading days and different public holidays in the United States and Israel). The
trading prices of our ordinary shares on these two markets may differ due to these and
other factors. Any decrease in the trading price of our ordinary shares on one of these
markets could cause a decrease in the trading price of our ordinary shares on the other
market.

15

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Future sales of our shares to be
registered for resale in the public market, as well as conversion of our convertible
securities, could dilute the ownership interest of our existing shareholders and could
cause the market price for our ordinary shares or convertible notes to fall.

As
of March 22, 2007, we had 15,374,124 ordinary shares outstanding (excluding 1,647,594 held
by two of our wholly owned subsidiaries). In addition, we reserved 2,145,017 ordinary
shares for issuance under our option plans. We also have certain commitments described
below to issue BluePhoenix ordinary shares and register them for resale, as follows:

| |  | 691,105
ordinary shares issuable upon conversion of debentures issued to institutional investors
in connection with the $5 million private placement completed in March 2004;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 485,714
ordinary shares issuable upon exercise of warrants issued to institutional investors in
connection with the $5 million and $3 million private placements, completed in March 2004
and March 2006, respectively; and
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 2,059,064
ordinary shares issuable upon conversion of the convertible notes traded on the TASE sold
by us in a public offering in Israel in February 2006.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------

For
information about the debentures and the warrants issued to the institutional investors,
see Item 5.B Liquidity and Capital Resources  Contractual Commitments and
Guarantees.

The
conversion of some or all of the convertible debentures held by the institutional
investors, the exercise of options and warrants held by investors, and the conversion of
the convertible notes traded on the TASE, would dilute the ownership interests of our
existing shareholders. Any sales in the public market of our ordinary shares issuable upon
such conversion could adversely affect the prevailing market prices of our ordinary
shares.

In
addition, certain of our shareholders, holding in the aggregate 9,655,663 ordinary shares,
have registration rights with respect to the shares they hold, including piggyback rights.
For more information about these rights, see Item 7.B Related Party Transactions
 Registration Rights Agreements.

If
a large number of our ordinary shares are sold in a short period, the price of our
ordinary shares would likely decrease.

In
addition, the price of our ordinary shares could be affected by possible sales of our
ordinary shares by investors who view the convertible notes as a more attractive means of
equity participation in our company and by hedging or arbitrage trading activity that may
develop involving our ordinary shares. The hedging or arbitrage could, in turn, affect the
trading price of the convertible notes.

16

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We
may be characterized as a passive foreign investment company, or PFIC, for U.S. federal
income tax purposes.

If,
for any taxable year, our passive income or assets that produce passive income exceed
levels provided by law, we may be characterized as a PFIC for U.S. federal income tax
purposes. This characterization could result in adverse U.S. tax consequences to U.S.
holders of ordinary shares. If we were classified as a PFIC, a U.S. holder of ordinary
shares could be subject to increased tax liability upon the sale or other disposition of
ordinary shares or upon the receipt of amounts treated as excess
distributions. United States holders should consult with their own U.S. tax advisors
with respect to the tax consequences of investing in our ordinary shares as well as the
specific application of the PFIC rules. For a more detailed discussion, see
TaxationUnited States Federal Income Tax ConsiderationsTax Consequences
if We Are a Passive Foreign Investment Company.

# ITEM 4. INFORMATION ON
THE COMPANY

|A. | History
and Development of the Company
|-- | --------------------------------------

We
were incorporated in Israel in 1987 under the name A. Crystal Solutions Ltd. In 1996, we
changed our name to Crystal Systems Solutions Ltd. In 2003, following the acquisition of
Liraz Systems Ltd., we changed our name to BluePhoenix Solutions Ltd. Our registered
office is located at 8 Maskit Street, Herzlia, 46120 Israel and our telephone number is
972-9-9526110. Our agent in the United States isBlue Phoenix Solutions USA Inc.,
8000 Regency Parkway, Cary, NC 27511 United States and its telephone number is (919)
380-5100.

We
run our worldwide operations through several wholly owned subsidiaries, named below:

| | Name of Subsidiary                    | Country of Incorporation
| | ------------------------------------- | ------------------------
|
|
|
|
| | BluePhoenix Solutions USA Inc.        | United States           
| | IntraComp Group Inc.                  | Unites States           
| | BluePhoenix Solutions Nordic ApS      | Denmark                 
| | BluePhoenix Solutions U.K. Ltd.       | United Kingdom          
| | BluePhoenix Solutions Srl.            | Italy                   
| | I-Ter/Informatica & Territorio S.p.A. | Italy                   
| | BluePhoenix Solutions GmbH            | Germany                 
| | BluePhoenix Solutions B.V.            | The Netherlands         
| | BluePhoenix Solutions Ltd.            | Cyprus                  
| | BluePhoenix Solutions Srl.            | Romania                 

For
information about our significant subsidiaries, see Item 4.C. Organizational
structure.

17

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Recent
Developments

In
December 2006, we acquired from CodeStream Software Ltd., or CodeStream, a key competitor
in providing IDMS database migrations, certain business assets and activities in the field
of modernization of legacy databases. The acquired activities enable us to provide IDMS
modernization products and services, enabling organizations to move their IDMS systems to
modern relational databases serving modern web based applications on Java, Microsoft .NET
or COBOL technology platforms. Pursuant to the purchase agreement, we hired 18 persons
previously employed by CodeStream and assumed all the obligations in respect of the
purchased activities. In consideration for the acquisition of CodeStreams assets and
activities, we paid to CodeStream £5.2 million (approximately $10.2 million).
We believe that this acquisition strengthens our position as a leading provider in the
market of database and application migrations.

|B. | Business
Overview
|-- | -----------------

Our Business

We
develop and market unique value driven enterprise IT modernization, or EIM, solutions that
enable companies to automate the process of modernizing and upgrading their mainframe and
distributed IT infrastructure in order to more effectively compete in todays
business environment. The combination of our comprehensive tools and services with our
unique methodology provides an efficient and cost-effective process for extending the
return on investment of existing enterprise IT assets. Our complete modernization
solutions consist of a combination of automated technologies and services that minimize
the risk through the whole life cycle of the modernization process. Our solutions are
based on technologies that support the four phases of the process, which we call:
Understanding, Migration, Remediation, and Redevelopment. The solutions allow companies to
fully leverage their current systems and applications, speed up and reduce the cost of the
renewal process, and effectively update their systems in order to adapt to new business
demands. In addition, by using our technologies our customers gain the added value of
extending their systems to be ready for future demands, such as service oriented
architecture, or SOA. Our modernization solutions are offered to customers in all business
market sectors, particularly financial services, automotive and governmental entities. In
addition, we provide consulting services such as application development services and
maintenance for core banking systems.

Our
solution portfolio includes software products, software tools, and services that address
the most pressing IT challenges which organizations and companies face today, including:

| |  | lack
of agility and responsiveness to changing business needs;
| | - | --------------------------------------------------------------

| |  | difficulty
in recruiting and retaining mainframe professionals;
| | - | ---------------------------------------------------------------

| |  | growing
cost of software licenses, maintenance and operations;
| | - | --------------------------------------------------------------

| |  | lack
of packaged software and new applications; and
| | - | ---------------------------------------------------

| |  | difficulties
in complying with new regulations.
| | - | -----------------------------------------------

18

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Our
solutions enable companies to:

| |  | effectively
plan and carry out strategic projects that provide real business value;
| | - | -----------------------------------------------------------------------------------

| |  | better
understand and manage their IT systems and resources;
| | - | ------------------------------------------------------------

| |  | easily
integrate packaged applications and build customized applications;
| | - | -------------------------------------------------------------------------

| |  | significantly
decrease maintenance, human resource, and technology costs;
| | - | -------------------------------------------------------------------------

| |  | quickly
migrate to modern databases, platforms, applications, and programming languages with a
proven suite                   of tools and services;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------

| |  | substantially
transform applications and databases in order to address regulatory and business changes;
and
| | - | -----------------------------------------------------------------------------------------------------------

| |  | directly
gain access to cutting edge technology and new business channels.
| | - | --------------------------------------------------------------------------

Our
comprehensive enterprise technologies span mainframe, midrange, and client/server
computing platforms. We have enhanced our expertise through the successful completion of
projects for many large organizations over the past two decades, establishing our
credibility and achieving international recognition and presence. Based on our technology
and that of our affiliates, we develop and market software products, tools, and related
methodologies. We deliver our tools and methodologies together with training and support
in order to provide enterprises with comprehensive solutions, primarily for the
modernization of existing IT systems.

Market Background

Companies
initiate IT modernization projects for a wide range of reasons, such as:

| |  | maintaining
a competitive edge in the market;
| | - | ---------------------------------------------

| |  | addressing
changing business needs;
| | - | -----------------------------------

| |  | complying
with new regulations;
| | - | -------------------------------

| |  | reducing
maintenance, human resources, and technology costs; or
| | - | ---------------------------------------------------------------

| |  | gaining
access to cutting edge technology and new business channels.
| | - | --------------------------------------------------------------------

Alternatives
to modernization, include, among others, renewing legacy systems, buying packaged
software, or rebuilding entire applications. Enterprise IT modernization has proven to be
the most efficient and viable way for companies to protect their existing investments. We
provide a range of solutions designed to efficiently address the challenge of retaining
the business knowledge built into the application code while updating the system to
reflect new requirements.

The
EIM market is divided into the following categories:

Enterprise
IT UnderstandingThese solutions enable companies to make informed strategic
decisions regarding the future of their IT systems by automatically capturing multiple
levels of operational and development information into a consolidated metadata warehouse.
Our tools facilitate global assessments and impact analyses of application assets, thus
helping reduce costs, streamline working processes, and increase efficiency.

19

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Enterprise
IT MigrationThese solutions enable companies to consolidate and eliminate a wide
range of legacy hardware and software through automated migration of applications,
databases, platforms, programming languages, and data. These tools help to reduce costs
and resources, and minimize reliance on proprietary technology, sunset products, and
dwindling skill sets. Our SOA-ready solution is provided as a post-migration service,
allowing customers to extend their development environment by providing access to
mainframe systems through Web services protocols, making legacy systems appear as modern
systems.

Enterprise
IT RemediationThese solutions enable companies to extend the life of their
existing IT systems by quickly adapting to new regulatory changes and business
requirements. These automated tools can be easily customized to fit any IT environment and
corporate need, including data field adjustment, IT standardization, and system
consolidation.

Enterprise
IT RedevelopmentThese solutions enable companies to mine existing applications
by extracting business rules, data flows, and data models, and then re-using the proven
code base to create more flexible Java/Web-based applications. Our tools help to reduce
maintenance costs and resources and application development time-to-market.

Enterprise IT
Understanding

In
the current lean budgetary environment, companies that want to extend the return on
investment of their existing systems need to modernize their legacy systems. Since
modernization projects are intricate and complex, the essential first step is a thorough
review of existing IT assets.

Our
understanding solutions provide automated, detailed mapping of system-wide IT
activity and the interconnections between all software components. This detailed road map
serves as the basis for optimizing the re-use of existing IT systems, tailoring the
modernization plan for the companys unique IT environment and corporate
requirements, and reducing future ongoing maintenance costs.

Modernization
initiatives that need to be based on an in-depth examination of actual system elements
include:

| |  | building
and rewriting enterprise-scale application components;
| | - | ---------------------------------------------------------------

| |  | implementing
new technologies such as Web-enablement;
| | - | -----------------------------------------------------

| |  | integrating
purchased and newly written applications;
| | - | -----------------------------------------------------

| |  | consolidating
servers and applications;
| | - | ---------------------------------------

| |  | migrating
to more modern platforms, databases and languages;
| | - | ------------------------------------------------------------

| |  | transforming
current applications to adapt to changing business standards; and
| | - | ------------------------------------------------------------------------------

| |  | protecting
against the loss of critical personnel and corporate knowledge base.
| | - | -------------------------------------------------------------------------------

Our
integrated set of enterprise IT understanding solutions are designed to assist
companies in achieving these goals by accurately mapping raw IT operational and
development data, down to the program code level, into a consolidated enterprise-wide
warehouse. The gathered information enables companies to keep track of system
inventories, resources, and interrelationships and to intelligently mine systems and
application metadata.

This
enterprise-wide view can then be used for a variety of strategic purposes, including:

20

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| |  | performing
impact, cost, and trend analyses as well as ongoing tracking of IT resources,
inventories, components, their usage and their interrelationships;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | running
business-logic analyses for business process identification, evaluation, extraction,
transition and                   enhancement;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------

| |  | achieving
significant cost reductions through the elimination of unused products, unnecessary
software upgrades, inefficient storage allocations, and wasteful CPU usage; and
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | providing
more efficient application development by reusing systems and leveraging existing
business rules.
| | - | -----------------------------------------------------------------------------------------------------------

BluePhoenix IT DiscoveryThis
solution provides fast and convenient access to application inventory, dependency, and
operational information. This tool performs the complete audit necessary to enable
companies to define and analyze all application assets in order to make informed
decisions about ongoing modernization activities. IT Discovery provides the
ability to analyze on a refreshable basis numerous technology environments, and from them
extract and report on the interrelationships among the components that make up these
environments. In this manner, it provides an organization the ability to discover
information about its current systems, thereby insuring that ongoing decisions are made
based on an accurate audit of the current environment.

BluePhoenix LogicMinerThis
recovery solution mines COBOL and extracts business rules from the legacy code, thus
providing IT departments with the ability to begin a modernization process based on
techniques that preserve the functionality of legacy code. This tool retains past
investments in software assets by producing reusable code objects or descriptive data
that can later be used for improving the quality of the legacy code, rewriting the legacy
application, or building a full modernization plan. LogicMiner increases a systems
manageability, while eliminating rules that no longer apply to current business
procedures.

Enterprise
IT Migration

Our
comprehensive, integrated set of enterprise IT migration solutions enable
companies to standardize and consolidate their IT systems by automatically converting and
redeploying applications, databases, platforms, programming languages and data that are
implemented on outdated computing platforms.

Buying
a packaged application or rebuilding one can often be an expensive and risky proposition.
Therefore, companies often look towards migrating their existing applications. This
option is much more cost-effective and time-efficient as it leverages their existing
investments in custom applications. Additionally, our migration solutions enable
companies to operate their IT systems independently, without relying on previous
technology support providers. Thus, the migration process provides significant cost
savings on development, maintenance, and human resources.

Our
migration solutions provide numerous advantages, including:

| |  | significantly
decreasing project costs, risk of errors and time;
| | - | ----------------------------------------------------------------

| |  | preserving
corporate business knowledge;
| | - | ----------------------------------------

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| |  | substantially
reducing dependency on scarce skill sets;
| | - | -------------------------------------------------------

| |  | solving
problematic maintenance issues;
| | - | ---------------------------------------

| |  | enabling
end-to-end project control and management;
| | - | ---------------------------------------------------

| |  | directly
supplying a full audit trail and documentation of all changes;
| | - | -----------------------------------------------------------------------

| |  | minimizing
system freeze time with a unique "refresh" feature; and
| | - | ------------------------------------------------------------------

| |  | comprehensively
working with most mainframe and non-mainframe platforms.
| | - | ------------------------------------------------------------------------

The
enterprise IT migration suite includes the following solutions:

BluePhoenix DBMSMigratorAn
automated migration tool that converts applications from nonrelational databases, such as
IDMS (Integrated Database Management System), ADABAS, IMS, and VSAM, to relational
databases, such as DB2, Oracle, and SQL Server. The tool performs automated conversions
that provide companies with fully functional compliance for source and target
applications and minimal application, functional, and logical program flow changes. DBMSMigrator leaves
no residuals, emulation software, or translation procedures and allows system support to
continue uninterrupted during the migration project. As a result of the conversion
process, the migrated application operates more efficiently, is easier to maintain, and
contains complete documentation of the customers knowledge base and guidelines.

BluePhoenix PlatformMigratorAn
automated migration tool that convertsa range of platforms, including VSE, MVS,
and Bull GCOS, to Unix, Linux, Windows, and .Net. PlatformMigrator can becustomized
to fit the unique IT configuration and business rules of each customer site. The tool
converts platforms to a pure, native installation so that programs are not required to
run under emulation or through translation techniques. PlatformMigrator solutions
assist companies with maintaining service levels, setting and upgrading standards,
implementing the new IT environment, training IT users, implementing new facilities like
a security system or a batch scheduler, and testing for functional equivalence.

BluePhoenix
 Rehosting Organizations implement mainframe rehosting in order to reduce the
ongoing costs of existing legacy CICS and batch applications. Rehosting leverages the
strength and investment of older COBOL applications while taking advantage of new,
cost-efficient hardware and open operating system environments such as Linux, Unix,
Windows, J2EE, and .NET.

Using
our various automated migration tools, and cooperating with our partners, we offer COBOL
migration and mainframe rehosting solutions. We formed the following alliances for
providing these solutions:

| |  | a
cooperation with Micro Focus for implementing their "Lift and Shift" strategy. Micro
Focus is a member of                     the Migration and Transformation Consortium
(MTC) for COBOL solutions;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | an
alliance with Clerity for assisting companies to rehost mainframe applications on more
cost-efficient,                     open platforms; and
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
collaboration with Fujitsu for assisting companies to migrate COBOL/CICS applications
into Fujitsu NetCOBOL and the Fujitsu NeoKicks and NeoBatch environments for handing CICS
and batch/JCL.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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BluePhoenix LanguageMigrator An
automated migration tool for converting COBOL and 4GLs (fourth generation languages) such
as ADSO, Natural, ALLFusion Gen (formerly COOL: Gen), Mantis, and PowerBuilder to COBOL
and Java/J2EE. This reliable, time-efficient, and comprehensive solution enables
site-wide installation, simultaneous testing, and implementation of batch programs. In
addition, LanguageMigrator identifies the compatibility of the code, converts it
to the new standards required by customers, and analyzes converted programs to identify
potential problems. For more information about future developments of this tool, see
Research and Development.

BluePhoenix DataMigrator A
Windows-based tool for migrating data between various data system environments. Coupled
with a step-by-step proven methodology, the tool provides a fully structured but still
versatile automated data migration process. DataMigratorenables full control of
source and target data definitions resulting in consistent, accurate, highest quality
target data with no data loss, and efficient utilization of available resources. In
addition, it provides support for partial or incremental migration and for multiple
runtime environments.

BluePhoenix
 SOA-Ready Enablement This post-migration service extends the useful life of
valuable legacy applications that run on historic mainframe platforms by allowing them to
be easily reused in a modern Web-centric environment. This comprehensive solution provides
Web services and Web customers for legacy applications. This unique set of tools enables
the exposure of a legacy application to more modern applications written in Java or .NET
by providing a Web service interface for the legacy system. Our tools also provide a
Web-based display for legacy (3270) applications. These tools are noninvasive and allow
the legacy application to remain untouched.

Enterprise IT Remediation

Our
integrated set of enterprise IT remediation solutions enable companies to extend
the life of their existing IT systems when facing ongoing regulatory changes and new
business requirements. Our remediation solutions address a variety of corporate
needs and include:

BluePhoenix FieldEnabler New
business decisions or regulatory requirements often require companies to make changes
that impact a wide range of system components. These include field adjustments that
involve changes in the type, length, and structure of a database or program field, such
as expanding a dealer code. FieldEnabler is a rule-based tool that enables a
step-by-step, comprehensive process for making these kinds of modifications across an
enterprise in a reliable and time-efficient manner.

BluePhoenix
 StandardsEnabler A highly automated solution for reliably facilitating system
consolidation into a single set of naming standards. Since all resources being converted
must be changed in parallel, the large task of manually standardizing the naming of system
components is not practical. Our tool provides an automated solution addressing this
problem.

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BluePhoenix
COBOL/LE-Enabler A highly automated solution that facilitates the migration of
COBOL code from non-LE compliant environments to LE compliant environments.

BluePhoenix
EuroEnabler A highly automated solution that enables the transformation of
applications to be euro compliant. EuroEnabler fully preserves system and data
integrity and helps to maintain existing levels of system application development and
maintenance throughout the process.

Enterprise IT
Redevelopment

Enterprise
IT environments are complex, and can prevent companies from quickly and easily adapting to
new business needs and requirements. The more companies can organize and understand their
applications, the faster they can adapt to inevitable changes. While organizations are
mostly satisfied with the existing business functionality of their applications, they
usually want to improve their business processes and leverage technologies such as
Web-enabled and service-oriented architectures. Additionally, they are eager to find a way
to decrease their maintenance costs, which typically consume 70%80% of total IT
spending.

Our
enterprise IT redevelopmentsuite enables companies to efficiently mine, reuse,
and rewrite their existing applications, thus incrementally redeveloping their legacy
systems, extending them into new technologies, and saving on development and programmer
costs.

BluePhoenix AppBuilderOur
primary redevelopment legacy environment has been used for managing, maintaining, and
reusing the complicated applications needed by large businesses. It provides the
infrastructure for enterprises worldwide, across several industries, with applications
running millions of transactions daily on legacy systems. Enterprises using AppBuilder can
build, deploy, and maintain large-scale custom-built business applications for years
without being dependent on any particular technology until they cease using their legacy
infrastructure. AppBuilder acts like a virtual application warehouse, keeping the
underlying structure of the system in an organized framework such that developers can
easily understand it. This allows companies to reuse critical business components,
realizing a long-term return on investment for both new and existing applications.

BluePhoenix  Redevelopment
 Based on AppBuilder and LogicMiner, Redevelopment transforms legacy
COBOL programs into service oriented applications deployed on the latest platforms. The
resulting application conforms to industry standards and is written in clean,
maintainable source code. This conformance to standard architectures, such as full
object-orientation and Web services, is a key differentiator in the Redevelopment approach
when compared to more common migrations. Instead of using the common approach where each
line of COBOL source code is translated to one or more statements in the target language
(known as 1-1 approach), Redevelopment uses a model based approach. Redevelopment develops
a platform independent model from platform specific models of legacy COBOL applications
identified by BluePhoenix LogicMiner. This platform independent model may then be
extended to meet new business requirements. Finally the application is generated to J2EE,
..NET, or COBOL.

Visual
MainWin® for the Unix and Linux platforms (formerly MainWin)Visual MainWin® for
the Unix and Linux platforms is an application-porting platform that enables independent
software vendors to develop applications in Visual C++ and deploy them natively on Unix
and Linux without the investment that is usually associated with designing and developing
a new source code base for Unix platforms.

24

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In
1994, Mainsoft entered into a licensing agreement with Microsoft, pursuant to which
Microsoft granted Mainsoft access to specified Microsoft source code, including new
versions, service packs, and upgrade releases for Windows. Microsoft also granted
Mainsoft distribution rights to the Windows object code licensed as a component in Visual
MainWin for Unix. Visual MainWin for Unix is already a mature product and Mainsoft
primarily focuses on supporting and maintaining its existing Visual MainWin for Unix customers.
We believe that our growth engine is the Visual MainWin for J2EE product described below.

Visual
MainWin® for the J2EE platformDuring 2006, Mainsoft continued to invest in
the research and development, sales and marketing of its new Visual MainWin® for
J2EEproduct, including the introduction of a Portal Edition. Mainsoft and IBM have
been collaborating to market Visual MainWin for J2EE to IBM customers using or
considering using WebSphere Portal in a mixed .NET-Java environment.

Investments and
Acquisitions

In
order to enhance our solutions and services portfolio, we have been pursuing a strategy of
adding new technologies to our suite of automated modernization tools. We implement this
strategy via internal development of new software tools and through acquisitions and
investments. Accordingly, we devote significant resources to the development and marketing
of new software modernization tools, and invest in businesses that develop software tools
that are complementary to our existing portfolio. The broad portfolio that we established,
among others, through these acquisitions, contributes to our ability to penetrate new
markets and to offer a complete set of solutions addressing the broad array of changing
demands of our customers. We integrate the acquired businesses into our business and
assimilate many of their functions, including, marketing, sales, finance and
administration into our existing infrastructure.

Following
is a description of our investments and acquisitions, which form a part of our business as
described above:

CodeStream
Software Ltd. In December 2006, we acquired from a company incorporated in
the United Kingdom, CodeStream Software Ltd., certain business activities in the field of
modernization of legacy databases, particularly IDMS and other mainframe platforms.
Pursuant to the purchase agreement, we hired 18 persons previously employed by CodeStream
and assumed all the obligations in respect of the purchased activities. In consideration
thereof, we paid CodeStream £5.2 million (approximately $10.2 million). In
addition, we undertook to issue to CodeStream a convertible debenture in a principal
amount of £2.9 million (approximately $5.7 million), if (i) not later than
December 14, 2008, we receive purchase orders from a key customer of CodeStream, in an
aggregate amount of not less than £2.2 million (approximately $4.3 million);
and (ii) such purchase orders are collectible under the purchase orders not later than
December 14, 2009. The debenture shall be issued upon the fulfillment of the
aforementioned conditions and shall be due two years after the date of issuance. The
debenture shall bear interest at a rate of LIBOR plus 1.5% calculated on a quarterly
basis. Interest shall be calculated on the principal amount of the debenture beginning on
December 14, 2006.

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In
addition, we undertook to issue to CodeStream a second convertible debenture in a
principal amount of £500,000 (approximately $982,000), if (i) not later than
December 14, 2010, we receive additional purchase orders from the same key customer of
CodeStream, in an aggregate amount of not less than £800,000 (approximately
$1.6 million); and (ii) such purchase orders are collectible not later than 36 months
after the first debenture was issued. The debenture shall be due two years after the date
of issuance and shall bear interest at a rate of LIBOR plus 1.5% calculated on a quarterly
basis. Interest will accrue on the principal amount of the debenture beginning on the date
of issuance of the first debenture.

The
debentures will be convertible into BluePhoenixs ordinary shares at a conversion
rate of $6.00 per ordinary share, subject to adjustment for stock dividends, stock splits,
recapitalization and other similar events. At the request of the holders of the
debentures, given six months in advance, we will repay the amount of the debentures prior
to their respective due dates. At the request of the holders of a majority of the shares
underlying each of the debentures, given within 10 business days after issuance of the
debenture, we will file a registration statement under the Securities Act 1933, referred
to as the Securities Act, for an offering of the shares underlying the debentures. In
addition, if we otherwise propose to register our ordinary shares under the Securities
Act, the holders of the debentures may request that we register their underlying shares as
well, subject to certain limitations. In the event that the repayment date of a debenture
occurs earlier than 6 months after the registration statement becomes effective, then, the
repayment date of the debenture shall be postponed until a date which is 6 months after
the effective date of the registration statement. In the event that holders of 50% or more
of the principal amount of a debenture request repayment of the debenture prior to its due
date, we shall be released from our undertakings with respect to the registration
described above.

BluePhoenix
Solutions Srl. (previously known as AlphaTech (2000) Srl.). In December
2002, we purchased from Intercomp, our affiliate, a 65% controlling interest in AlphaTech
(2000) Srl. for aggregate consideration of $100,000. In February 2005, we entered into an
agreement with the other shareholder of AlphaTech to purchase for $250,000 its entire
holdings in AlphaTech, which as of such date was equal to 35% of AlphaTechs
outstanding share capital. In 2005, AlphaTech changed its name to BluePhoenix Solutions
Srl. BluePhoenix Solutions Srl., a company incorporated in Romania, serves as our offshore
delivery center in Romania.

CePost. In January 2004, we purchased the entire outstanding share
          capital of CePost Ltd., an Israeli company that develops and markets software
          solutions for electronic document mining, management and presentment. Pursuant
          to the purchase agreement, we paid to the shareholders of CePost $172,500 and
          issued to them 31,496 BluePhoenixs ordinary shares. In addition, we
          undertook to pay to the sellers royalties from CePosts revenues in an
          amount of up to $1.5 million. At our option, we may pay the royalties in
          BluePhoenixs ordinary shares. In accordance with the purchase agreement,
          we paid to the sellers in 2005 and 2006 advances in an aggregate amount of
          $45,000 on account of the royalties.

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Intercomp.        In
1998, we invested in Intercomp Ltd., which has developed a set of automated
          analysis and reengineering tools for legacy COBOL applications. During 2002 and
          2003, Intercomp focused its efforts on the development of software tools that
          comprise a part of BluePhoenix LogicMiner. For more information about
          LogicMiner, see Research and DevelopmentEnterprise IT
          UnderstandingBluePhoenix LogicMiner.

In
2004, we exercised an option granted to us to purchase from Eran Tirer all of its holdings
in Intercomp, constituting 18.5% of the outstanding share capital of Intercomp. In
consideration, we issued to Mr. Tirer warrants to purchase BluePhoenix ordinary shares
which expired without being exercised. As part of the transaction with Mr. Tirer, certain
shareholders of Intercomp, holding 2.1% of Intercomps outstanding share capital,
transferred to us their holdings in Intercomp. In addition, the remaining shareholders of
Intercomp comprised of several funds acting through their general partner, Infinity,
converted certain outstanding loans owed to them by Intercomp into 7,236 shares of
Intercomp at a price of $162.70 per share. Following these transactions, our holdings in
Intercomp increased from 49% to approximately 62%. Since the end of the first quarter of
2004, we consolidat the results of operations of Intercomp.

Concurrently
with the grant by Mr. Tirer of the option to purchase from him his holdings in Intercomp,
Intercomp granted nonexclusive rights to a distributor partially owned by Mr. Tirer, to
further develop and distribute Intercomps products.

In
April 2004, Infinity granted us a call option to purchase its entire holdings in
Intercomp. The option expired without being exercised by us. As a result, Infinity
exercised a put option granted to it, to cause us to purchase Infinitys entire
holdings in Intercomp. In consideration for Intercomps shares, we issued to Infinity
100,719 BluePhoenix ordinary shares. As previously agreed with Infinity, we filed a
registration statement under the Securities Act with respect to the ordinary shares issued
to Infinity. Subsequent to the exercise of the option by Infinity, we currently wholly own
Intercomp.

In
the first quarter of 2006, FIMI, a creditor of Intercomp, has completed exercising a put
option to sell to us convertible promissory notes issued by Intercomp, in an aggregate
principal amount of $3.5 million. The put option was originally granted to FIMI in January
2001. As consideration thereof, we paid FIMI an aggregate amount of $4.48 million
including interest accrued, which equals the book value of the promissory notes, and
issued to FIMI warrants to purchase 210,000 BluePhoenixs ordinary shares at an
exercise price of $4.00 per share. No gain or loss was recorded at the repayment date. In
the first quarter of 2007 FIMI exercised all its warrants.

I-Ter/Informatica & Territorio S.p.A.In the second quarter of 2005, we
entered into an agreement to purchase the entire outstanding share capital of I-Ter. I-Ter
is a developer and marketer of software solutions for migration from DL1 to DB2, and from
IMS/DC to CICS, porting of applications from mainframe and Unix Sun Solaris. Pursuant to
the purchase agreement, we paid to the selling shareholders of I-Ter $1.4 million. Under
the terms of the transaction, we agreed to pay the selling shareholders an additional
consideration of up to $720,000 calculated based on I-Ters cumulative earnings
before interest and taxes, referred to as EBIT. As agreed, if the EBIT in any calendar
year during the three-year period commencing on January 1, 2005, is equal to or greater
than $6,000, we will pay the selling shareholders an additional $240,000 with respect to
each such year. In 2006, we paid to the selling shareholders $240,000 since I-Ter met the
criteria in 2005. In 2006, the EBIT exceeded the minimal level, and therefore we are
required to pay the selling shareholders $240,000. In addition, we agreed to pay to the
selling shareholders, at such date that is 15 business days following the date on which
the EBIT report for the year ended on December 31, 2007 is final, additional consideration
equal to seven times the yearly average EBIT in the three-year period commencing on
January 1, 2005, less the amounts already paid to the selling shareholders for the
purchased shares. In addition, in the event that the yearly average EBIT in the three-year
period commencing on January 1, 2005 is greater than $600,000, we shall pay the selling
shareholders an amount equal to nine times of the difference between the yearly average
EBIT in the three-year period commencing on January 1, 2005 and $600,000.

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MultiConn. In 1999, we acquired 51% of the outstanding share           capital of
M.S.I. MultiConn Solutions International (1995) Ltd., referred to as           M.S.I.
MultiConn, and in 2000, we increased our shareholdings in M.S.I.           MultiConn to
60%. Effective as of January 2004, the other shareholders of M.S.I.           MultiConn
transferred their entire holdings in M.S.I. MultiConn to us. Following           this
transaction, we assumed control over the daily management of M.S.I.           MultiConn.
We currently wholly own M.S.I. MultiConn and finance its activities.

In
2000, we established together with the other shareholders of M.S.I. MultiConn, a company
named MultiConn Technologies Ltd. and initially owned 19% of its share capital. MultiConn
Technologies develops and markets BluePhoenix SOA  Ready Enablement. In 2002,
we increased our holdings in MultiConn Technologies to 60%. Following a transaction
entered into between us and the other shareholders of MultiConn Technologies in 2004, the
other shareholders of MultiConn Technologies increased their holdings in MultiConn
Technologies to 58.2% in the aggregate, through the issuance of shares by MultiConn
Technologies. As a result, we currently hold approximately 40% of the outstanding share
capital of MultiConn Technologies. We have an option to increase our holdings in MultiConn
Technologies to 60% of its outstanding share capital for an exercise price of $50,000. As
of March 22, 2007, we lent to MultiConn Technologies an aggregate amount of $2.5 million.
In 2004, we included in our equity in affiliated companies 100% of the losses of MultiConn
Technologies. As of December 31, 2004, we consolidate MultiConn Technologies balance
sheet with ours. For more information about BluePhoenix SOA  Ready Enablement,
see Enterprise IT MigrationBluePhoenix SOA  Ready
Enablement.

Outlook. Effective
as of January 2004, we acquired from an Israeli           company, Outlook Systems Ltd.,
through our new wholly owned subsidiary, Outlook           & BluePhoenix Ltd.,
Outlook Systems entire business activities in           Israel in the field of
software development services. Pursuant to the purchase           agreement, we hired 31
employees previously employed by Outlook Systems and           assumed all the
obligations in respect of the purchased activity. Under the           purchase agreement,
as amended in 2006, we paid to Outlook Systems an aggregate           amount of
approximately $1.3 million. In accordance with the amendment to the           purchase
agreement, a guarantee given by us to secure bank loans of Outlook           Systems, was
cancelled. In addition, Outlook Systems received 138,591 of           BluePhoenix
ordinary shares. As part of the amendment, we undertook to pay           Outlook Systems
a consideration to be calculated based on Outlook &          BluePhoenix Ltd.s
annual earnings before interest and taxes, referred to           as EBIT, during the
three-year period commencing on July 1, 2005, as follows:

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| |  | For
an amount of up to $300,000 of the annual EBIT in each year within the three-year EBIT
period, we will pay Outlook Systems a consideration equal to 10% of the EBIT;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | For
an amount of annual EBIT in a fiscal year within the three-year EBIT period in excess of
$300,000, we will pay Outlook Systems additional consideration equal to 15% of the
excessive amount.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Based
on the EBIT during the eighteen months commencing on July 1, 2005, the accrued contingent
consideration is $35,000.

Zulu
Software Inc. In February 2005, we entered into an agreement to purchase up
to 20% of the outstanding share capital of Zulu Software, Inc., or Zulu, on a fully
diluted basis. Under the purchase agreement, the purchase price was divided into four
installments, each to be paid subject to fulfillment of a certain milestone. We paid the
first installment of $350,000 in February 2005 against the issuance to us of 8% of
Zulus outstanding share capital. We have not made additional payments because the
agreed upon milestones have not been met. In January 2006, we purchased from the other
shareholders of Zulu additional shares increasing our holdings to 72% of Zulus
outstanding share capital. The aggregate consideration we paid for this additional
purchase was $2.4 million. Zulu is a developer and marketer of software solutions for
migration from ADABAS/Natural to Java. For more information about Zulus software
solutions, see Enterprise IT MigrationBluePhoenix
LanguageMigrator.

Cicero
Inc.(formerly Level 8 Systems Inc.). As of March 22, 2007, we hold
several capital instruments, including warrants and rights to receive warrants,
exercisable into shares of Cicero Inc. If we exercise these capital instruments in full,
we will hold approximately 545,000 ordinary shares of Cicero. As of March 22, 2007, we
provided Bank HaPoalim with a guarantee securing Ciceros bank loans, in an
amount of approximately $2 million. The guarantee is extended from time to time and it is
currently in effect until November 2007. In consideration for the extension of the
guarantee, Cicero issues to us ordinary shares. In the event that the guarantee is
exercised, the bank is obligated to grant to us a loan for a three-year period in an
amount of up to the amount of the guarantee.

In
September 2004, we extended a loan to Cicero of approximately $97,000 under a secured
promissory note. The note bears interest at an annual rate of 10%. In consideration, we
are entitled to receive warrants to purchase 19,865 ordinary shares of Cicero at an
exercise price of $1 per share.

Customers

We
provide our modernization solutions directly or through our strategic partners, such as
IBM, EDS, NCS, Matrix, and TACT. Additionally, from time to time, other IT services
companies license our technologies for use in modernization projects in various markets.
Our partners are usually system integrators who assist us in increasing our penetration
and exposure in the market. We provide solutions to our partners customers in
collaboration with the system integrators team. In most cases, the partners provide
related services to the customers. Our arrangements with our partners vary. We may enter
into distribution agreements with our partners under which we grant license rights or to
the partners customers, provide related services, or a combination of both.
Alternatively, we may enter into subcontractor relationships with our strategic partners.

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A
substantial portion of our agreements are based on fixed price contracts. These projects
may bear some risks and uncertainties as we price these contracts based on estimates of
future costs, duration of the project and the impact of potential changes in the scope of
the work. We also enter into other types of contracts, including annual maintenance
contracts, license agreements and arrangements on a time and material basis. To date,
shifts in revenues generated from different types of agreements have not materially
affected our results of operations.

Our
customers include, among others:

|Financial Services | Insurance                                 | Other Industries
|------------------ | ----------------------------------------- | ----------------
|                   |                                           |                 
|                  | Citibank                                  |                
|                  | Credit Suisse                             |                
|                  | Fidelity InternationalResource Management |                
|                  | Laiki Group                               |                
|                  | Rabobank Netherland BV                    |                
|                  | Rural ServiciosInformaticos (Spain)       |                
|                  | SDC Udvikling (Denmark)                   |                
|                   |                                           |                 
|                  | Woolwich PLC                              |                
|                   |                                           |                 
|                   |                                           |                 
|                   |                                           |                 
|                   |                                           |                 
|                   |                                           |                 
|                   |                                           |                 
|                   |                                           |                 

Each
of the customers mentioned above contributed at least $600,000 to our annual revenues for
a project performed within the previous two fiscal years.

SDC
Udvikling A/S, referred to as SDC Udvikling, an affiliated company of SDC, accounted for
11% and 17% of our revenues in 2006 and 2005, respectively.

Temenos
group accounted for 15% of our revenues in 2006.

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The
following table summarizes the revenues from our tools and services by geographic regions
for the periods indicated

|                            | Year ended December 31,
|--------------------------- | -----------------------
|
|
|
|
|United States               |                        
|Europe (other than Denmark) |                        
|Denmark                     |                        
|Israel                      |                        
|Other                       |                        
|                            |                        
|                            |                        
|Total                       |                        

Research and Development

In
order to maintain our position as a market leader in the IT modernization market, we are
focusing our development efforts on further enhancements to current solutions, as well as
addressing newly emerging aspects of the modernization market. We are planning additional
software development activities to extend our modernization solutions by leveraging our
technological skills to create added value for our customers and to generate additional
business opportunities.

The
next generation of our solutions will be extended to address the entire modernization
process from legacy systems to modern platforms. We have started to develop our next
generation of products and tools, which will allow the fluent transformation of legacy
code to state-of-the-art platforms, such as J2EE and .NET. The new generation of solutions
is composed of products and tools in several EIM categories.

Enterprise IT
Understanding

BluePhoenix
IT Discovery By further refining our existing understanding technology and
combining it with the additional technology licensed from Merrill Lynch, IT Discovery
will provide the basis for legacy understanding needed by the rest of our modernization
solutions.

Enterprise IT Automated
Migration

Fourth
Generation Language MigrationIn the area of automated migration, we continue to
build on our 4GL migration solutions. Our assets in the migration area cover COOL:Gen,
Mantis, ADSO/IDMS, Natural, CSP, and PowerBuilder transformations. We continue to extend
the support target platform of these transformations to include J2EE and .NET platforms.

Enterprise
IT SOA Ready SolutionA comprehensive solution that provides Web services or
clients for a legacy application. Our unique suite of tools enables a legacy application
to be exposed to more modern applications written in Java or .NET by providing a web
service interface for the legacy system. In addition, our tools are able to provide a web
based appearance/ connectivity/ interface legacy applications. Both solutions are not
intrusive and allow the legacy application to remain untouched.

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BluePhoenix LogicMinerA
comprehensive solution for recovery that mines COBOL and extracts business rules from the
legacy code, thus providing IT departments with the ability to begin a modernization
process based on techniques that preserve the functionality of a legacy code. This tool
retains past investments in software assets by producing reusable code objects or
descriptive data that can later be used for improving the quality of the legacy code,
rewriting the legacy application, or building a full modernization plan. LogicMiner increases
a systems manageability, while eliminating rules that no longer apply to current
business procedures.

BluePhoenix Refactoring
RepositoryA repository that supports the storage and management of the abstract
models and code of applications that make use of multiple development architectures such
as legacy information engineering and more modern object oriented and service oriented
architectures.

BluePhoenix Redevelopment Once
legacy models and code are refactored, Redevelopment will provide the ability to
generate from the abstract platform independent model stored in the Refactoring
Repository to platform specific models such as J2EE and .NET. To address this, we are
extending robust generation technologies to generate platform specifics for object
orientation and SOA. This model driven modernization environment can be used to gradually
migrate applications rather than requiring an all at once approach. In order
to address refactoring, which involves changing from one application model to another, we
are adding the necessary tools to assist in the process of taking the information from
legacy applicationsarchitectures via LogicMiner to more modern architectures
such as object and SOA.

Mainsofts
Visual MainWin® for the J2EE platformMainsofts Visual MainWin® for
the J2EE platform is a cross-platform development solution that bridges the .NET/J2EE
divide, enabling Visual Basic .NET and C# developers to develop J2EE Web applications and
Web services using the Visual Studio .NET development environment. Version 1.7 of Visual
MainWin® for the J2EE platform, introduced in December 2005, supports the IBM
partnership, including validation on all IBM eServer product line and support for IBM
WebSphere Express and WebSphere Application Server 6.0. In 2006, Mainsoft identified the
enterprise portal market opportunity and launched a portal edition of the product
supporting IBM WebSphere Portal. This product is based on the Mono project, an open
source .NET implementation, led by Novell and it is not dependant upon Microsoft source
code.

Mainsoft
continues to market Visual MainWin for Unix. Its current release supports Visual Studio
2005 and additional UNIX and Linux platforms.

Costs and Grants

As
of December 31, 2006, we employed 150 employees in our software development departments.
Our net development expenditures were $9.4 million in 2006, $8.0 million in 2005 and $8.1
million in 2004. Certain of our new product development projects have been awarded
research grants, of which some that are repayable as royalties.

32

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Chief Scientist Grants

Visual
MainWin® for J2EE PlatformThrough December 31, 2006, our subsidiary,
Mainsoft, accrued an aggregate of approximately $1.8 million in grants from the Office of
the Chief Scientist, or the OCS, for the development of Visual MainWin® for J2EE.
Royalties of 3% are payable to the OCS on sales of Visual MainWin® for J2EE, up to
100% of the dollar-linked grant received in respect of the funded product. To date,
Mainsoft has paid the royalties to the OCS as required. Mainsoft has submitted to the OCS
an application for obtaining research and development grants for 2007, which is pending
approval.

PowerTextAs
of January 1, 2004, we received through our wholly owned subsidiary, an aggregate of
approximately $200,000 in grants from the OCS for the development of PowerText. PowerText
is a software solution for automated electronic document mining, management and
presentment. Royalties of 3% are payable to the OCS on all sales of PowerText up to 100%
of the dollar-linked grant received. To date, CePost has paid to the OCS the royalties as
required.

BluePhoenix SOA
 Ready EnablementThrough December 31, 2004, our subsidiary, MultiConn
Technologies, accrued an aggregate of approximately $580,000 in grants from the OCS, for
the development of BluePhoenix SOA  Ready Enablement. Royalties of 3% are
payable to the OCS on sales of BluePhoenix SOA  Ready Enablement up to 100%
of the dollar-linked grant received in respect of the funded product.

Thebalance
of the contingent liability relating to the royalties payable by our subsidiaries to the
OCS, at December 31, 2006, amounted to approximately $2.5 million.

Other Grants

In
the first quarter of 2004, the Singapore-Israel Industrial Research and Development
Foundation agreed to provide one of our wholly owned subsidiaries together with a company
incorporated in Singapore, financing for the development of a Java report generator based
on legacy text file input. Accordingly, the foundation agreed to award our subsidiary up
to $100,000 payable according to an agreed upon schedule. As of March 22, 2007, we
received $45,000 of the grant. The grant is required to be repaid in installments based on
sales of the funded product up to the amount of the grant.

Our
subsidiary, I-Ter, is entitled to funds to develop Easy4Plan product, from the Ministry of
Production in Italy. Easy4Plan is a workflow management tool designed for ISO9000
companies. Approximately 30% of the funds are a grant, and the balance is an 8-year loan
to be repaid by I-Ter. The loan bears a minimal annual interest. The development term
ended in September 2006. Pending the final approval of the Ministery of Production, we
anticipate that during 2007, I-Ter will receive a total aggregate amount of approximately
$650,000.

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Intellectual Property

We
rely on a combination of trade secret, copyright, and trademark laws and nondisclosure
agreements, to protect our proprietary know-how. Our proprietary technology incorporates
processes, methods, algorithms, and software that we believe are not easily copied.
Despite these precautions, it may be possible for unauthorized third parties to copy
aspects of our products or to obtain and use information that we regard as proprietary.
However, we believe that with regard to most of our solutions, because of the rapid pace
of technological change in the industry, patent and copyright protection are less
significant to our competitive position than factors such as the knowledge, ability, and
experience of our personnel, new product development, and ongoing product maintenance and
support.

# Competition

The
modernization market in which we operate is highly competitive. The principal competitive
factors affecting the market for our modernization solutions include:

| |  | product
functionality, performance, and reliability;
| | - | ----------------------------------------------------

| |  | technical
range of the offered solutions;
| | - | -----------------------------------------

| |  | integration
between the offered solutions;
| | - | ------------------------------------------

| |  | availability
of experienced personnel and its expertise;
| | - | --------------------------------------------------------

| |  | prices;
| | - | -------

| |  | ability
to respond in a timely manner to changing customer needs;
| | - | -----------------------------------------------------------------

| |  | quality
of support and vertical market expertise.
| | - | -------------------------------------------------

Competition
in the enterprise IT modernization field is, to a large extent, based upon the
functionality of the available tools and personnel expertise. Vendors in this market
address the modernization of legacy systems in different ways, and therefore do not always
compete directly with the others. Many small vendors address only a small part of the
market, providing IT specific solutions. Only a few vendors offer more comprehensive and
integrated tools and solutions that can respond to the most challenging modernization
issues that companies are facing. Some large vendors, such as Oracle, HP and Intel have
joined forces to lead the market in an organized mainframe modernization initiative, the
Application Modernization Initiative (AMI). These three vendors also intend to create a
selected consortium of vendors in order to broaden the depth and breadth of their
migration offering.

Our
principal competitors consist of system integrators, offshore outsourcers, and tool
vendors, including leading software developers, who enable the replacement or
modernization of legacy systems. Major system integrators in the market include IBM,
Accenture, Capgemini, and EDS. IBM has established legacy modernization as a strategic
aspect of its long-term application development strategy. Major system integrators have a
specific and dominant advantage in the underlying application development infrastructure
associated with many legacy environments (predominantly IBM mainframes) and a large
service delivery capability. In some cases, we cooperate with some of these system
integrators in providing specific solutions or portions of comprehensive projects. Major
offshore outsourcers in the market include TCS (Tata Consulting Services), WIPRO, Patni,
and Infosys. Both systems integrators and offshore outsourcers have vertical market groups
offering consulting and professional services.

We
also face competition from niche tools and solutions companies operating in each of the
four principal areas of the enterprise IT modernization market:

| |  | Enterprise
IT Understanding;
| | - | ----------------------------

| |  | Enterprise
IT Migration;
| | - | ------------------------

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| |  | Enterprise
IT Remediation; and
| | - | ------------------------------

| |  | Enterprise
IT Redevelopment.
| | - | ----------------------------

For
example, Cast Application Intelligence Platform reads application source code to analyze
the fine-grained relationships among software artifacts  objects, functions, stored
procedures, database tables and columns, scripts and others. MetaWare provides services
and products such as re-hosting, database and programming language conversions. Most
Software Technologies addresses the ADABAS/Natural arena, and other competitors focus on
collecting sufficient information about application portfolios to improve business
processes. Other solution developers provide distributed repository solutions and
architecture modernization services.

|C. | Organizational
Structure
|-- | ------------------------

We
are part of the Formula group, a global IT solutions and services group headquartered in
Israel. The Formula group is principally engaged in providing software consulting
services, developing proprietary software products, and providing computer-based business
solutions. The Formula group delivers its solutions in over 50 countries worldwide to
clients with complex IT services needs, including a number of Fortune 1000
companies. We are a subsidiary of Formula Systems (1985) Ltd., which holds 52.3% of our
ordinary shares.

Following
is a list of our significant subsidiaries, their country of incorporation, and proportion
of our ownership interest in them, as of March 22, 2007:

|Name of Subsidiary   | Country of Incorporation | Proportion of Ownership Interest
|-------------------- | ------------------------ | --------------------------------
|
|
|
|
|BluePhoenix          | The Netherlands          | 100%                            
|                    
|Liraz Systems Ltd.   | Israel                   | 100%                            
|                    
|Mainsoft Corporation | United States            | 58%                             

|D. | Property,
Plants and Equipment
|-- | ------------------------------

We,
together with our subsidiaries and affiliates, currently occupy approximately 9,800 square
meters of office space. The aggregate annual rent we paid for these facilities in 2006 was
$1.9 million. The following table presents certain information about our facilities and
the terms of lease of these facilities.

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|Country and State   | City          | Sq. Meters | Expiration     | Annual anticipated
rental fees in
2007(*)
in thousands $
|------------------- | ------------- | ---------- | -------------- | --------------------------------------------------------
|
|
|
|
|Israel              | Herzlia       | 2,170      | December 2008  | 375                                                     
|Israel              | Holon         | 253        | February 2007  | 30                                                      
|Israel              | Lod           | 1,076      | June 2007      | 146                                                     
|USA, North Carolina | Cary          | 860        | April 2009     | 200                                                     
|USA, California     | San Jose      | 350        | November 2007  | 80                                                      
|USA, California     | Santa Clara   | 160        | October 2008   | 36                                                      
|USA, Indiana        | South Bend    | 400        | February 2008  | 84                                                      
|Denmark             | Ballerup      | 1,759      | November 2008  | 365                                                     
|Germany             | Frankfurt     | 265        | November 2007  | 48                                                      
|Romania             | Bucharest     | 900        | November 2007  | 162                                                     
|United Kingdom      | Uxbridge      | 40         | August 2007    | 54                                                      
|United Kingdom      | Milton Keynes | 80         | June 2007      | 112                                                     
|Cyprus              | Nicosia       | 800        | June 2009      | 132                                                     
|Italy               | Milan         | 150        | October 2010   | 30                                                      
|Italy               | Riccione      | 330        | December 2010  | 42                                                      
|Italy               | Milano        | 110        | April 2012     | 18                                                      
|Italy               | Roma          | 124        | September 2011 | 34                                                      
|Total               |               | 9,827      |                | 1,948                                                   

(*)           Includes
related fess such as management fees, maintenance, parking etc.

If,
in the future, we determine that we need additional space to accommodate our growth, we
believe that we will be able to obtain this additional space without difficulty and at
commercially reasonable prices. We do not own any real property.

# ITEM 4A. UNRESOLVED
STAFF COMMENTS

Not applicable.

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# ITEM 5. OPERATING AND
FINANCIAL REVIEW AND PROSPECTS

# Background

We
develop and market unique value driven enterprise IT modernization solutions that enable
companies to automate the process of modernizing and upgrading their mainframe and
distributed IT infrastructure and to effectively compete in todays environment. The
combination of our comprehensive set of products and tools with our expert services
methodology provides an efficient and cost-effective process for extending the return on
investment of existing enterprise IT assets. Our solutions, which include technology for
Understanding, Migration, Remediation, and Redevelopment, allow companies to
fully leverage their current systems and applications, speed up and reduce the cost of the
renewal process, and effectively update their systems in order to adapt to new business
demands.

Our
quarterly and annual results of operations have fluctuated significantly in the past and
we expect them to continue to fluctuate significantly in the future, as a result of
numerous factors, including the changes in the suite of modernization tools we have been
offering to our customers, the impact of acquisitions and dispositions of companies, and
the difficulties we have encountered in introducing our tools to the markets. Therefore,
we believe that period-to-period comparisons of our financial results are not necessarily
meaningful and you should not rely on them as an indication for future performance.

The
following discussion of our critical accounting policies and our financial condition and
operating results should be read in conjunction with our consolidated financial statements
and related notes, prepared in accordance with U.S. GAAP for the years ended December 31,
2006, 2005 and 2004, and with any other selected financial data included elsewhere in this
report.

# Overview

General

In
recent years, we have been affected by the global economic changes, in particular trends
in capital spending in the information technology sector. During 2001 through 2003, the
overall business slowdown in the North American and European markets influenced the
purchasing patterns of leading software developers who delayed their planned orders and
caused developers to reduce the amount of their planned commitment. These changes in
purchasing patterns in the IT industry directly affected our operating results. Our
revenues decreased from $49.2 million in 2000 to $38.4 million in 2001 and to $36.7
million in 2002. Since 2003, as a result of a recovery of the market, and the impact of
strategic acquisitions we completed, this trend changed, and our revenues increased from
$57.2 million in 2004 to $58.9 million in 2005 and $68 million in 2006. As part of this
change, our average backlog increased from approximately $25 million at the end of 2004 to
$50 million at the end of 2005 and $80 million at the end of 2006. This increase improves
managements ability to engage in near-term planning. We typically fill current
backlog within one year.

In
providing our solutions, we work closely with our customers or system integrators, and can
therefore be impacted by holiday seasons of customers and system integrators. As a result,
we may sometimes experience a decline in our third quarter revenues due to the summer
holiday season in Europe and Israel.

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In
order to enhance our solutions and services portfolio, we have been pursuing a strategy of
adding new technologies to our suite of automated modernization tools. We implement this
strategy via internal development of new software tools and through acquisitions and
investments. Accordingly, we devote significant resources to the development and marketing
of new software modernization tools. In addition, we invest in businesses that develop
software tools that are complementary to our existing portfolio and have a skilled and
specialized workforce.

Challenges and
Opportunities

Our
principal objective is to enhance our revenues by leveraging the marketing resources and
skilled specialized workforce to market the suite of tools and solutions that we offer. In
addition, we have identified a market demand for complementary application development
services. Our SOA-ready solution is provided as a post-migration service, allowing
customers to extend their development environment by providing access to mainframe systems
through Web services protocols, making legacy systems appear as modern systems. Therefore,
we anticipate an increase in revenues generated from our customers, by offering them
SOA-ready solutions and other post-migration services.

The
principal challenge we face is to accomplish our growth objectives while also enhancing
profitability. In order to expand our revenue base, we will continue to invest in our
sales and marketing operations and penetrate additional markets such as Far East Asia. In
preparation for the expansion of our business we are anticipating the need to expand our
off-shore delivery centers. As part of this process we will evaluate the viability of
moving or consolidating support and delivery centers to continue to increase efficiencies
and margins.

Since
our margins are dependent on the degree of automation of our tools, we plan to continue
devoting substantial resources to research and development both internally and through
acquisitions. There is no assurance that these investments will lead to revenue growth. If
they do not lead to growth as anticipated, our profitability will be adversely affected.

Since
2003, we have been enhancing our offshore delivery centers in Romania and Cyprus, where
our operational costs are lower. These offshore centers allow us to reduce the prices we
charge our customers for our solutions and simultaneously improve our operating profit.
Recently, professional work in these countries became more expensive and professional fees
may continue to increase in the future. As a result, we may consider establishing offshore
facilities in other countries. The establishment of such additional facilities, may result
in significant capital expenses which may affect our cash position. As the degree of
automation of our tools increases, the need for expert services decreases, and as a
result, our direct expenses decrease. In addition, the improved tools enable us to
implement our distributed project methodology, and simultaneously use our delivery centers
that perform the actual modernization project with our tools.

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Consolidation of the
Results of Operations of Our Subsidiaries

Following
is information regarding the consolidation of the results of operations of certain of our
subsidiaries, for the periods indicated. We began to consolidate the results of operations
of each of these subsidiaries when we acquired control in them.

|Name of Subsidiary                    | Beginning Consolidation
|------------------------------------- | -----------------------
|
|
|
|
|CePost Ltd.                           | First quarter of 2004  
|Outlook & BluePhoenix Ltd.            | First quarter of 2004  
|Intercomp Ltd.                        | Second quarter of 2004 
|MultiConn Technologies Ltd.           | First quarter of 2005  
|I-Ter/Informatica & Territorio S.p.A. | Second quarter of 2005 
|Zulu Software Inc.                    | First quarter of 2006  

Critical Accounting
Policies

We
prepare the consolidated financial statements of BluePhoenix in conformity with U.S. GAAP.
Accordingly, we are required to make certain estimates, judgments and assumptions that we
believe are reasonable based upon the information available. These estimates and
assumptions affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the periods
presented. The significant accounting policies that we believe are the most critical to
aid in fully understanding and evaluating our reported financial results include the
following:

| | Revenue
recognition. Our revenue recognition policy is significant because our revenue is a
key component of our results of operations. We follow specific and detailed guidelines in
measuring revenue; however, certain judgments affect the application of our revenue
policy. Revenue results are difficult to predict and any shortfall in revenue or delay in
recognizing revenue could cause our operating results to vary significantly from quarter
to quarter and could result in future operating losses. Should changes in conditions
cause management to determine that these guidelines are not met for certain future
transactions, revenue recognized for any reporting period could be adversely affected.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | We
recognize revenues from direct software license agreements in accordance with statement
of position (SOP) 97-2 Software Revenue Recognition (as amended by SOP 98-4
and SOP 98-9) upon delivery of the software when collection is probable, the license fee
is otherwise fixed or determinable, and persuasive evidence of an arrangement exists.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | When
a project involves significant production, modification or customization of software, and
with respect to fixed fee contracts, revenue is generally recognized according to the
percentage of completion method in accordance with the provisions of SOP 81-1 Accounting
for performance of Construction-Type Contracts. Under this method, estimated
revenue is generally accrued based on costs incurred to date as a percentage of total
updated estimated costs. If we do not accurately estimate the resources required or the
scope of work to be performed, or do not manage our projects properly within the planned
periods of time or satisfy our obligations under the contracts, then future margins may
be significantly and negatively affected or losses on existing contracts may need to be
recognized. Any such resulting reductions in margins or contract losses could be material
to our results of operations. We recognize contract losses, if any, in the period in
which they first become evident.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| | Under
some of our agreements, the customer may have the right to receive unspecified upgrades
on a when-and-if available basis. These upgrades are considered post-contract customer
support, referred to as PCS, and the fair value allocated to this right, is recognized
ratably over the term of the PCS.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | There
are no rights of return, price protection or similar contingencies in our contracts.
Accordingly, we do not establish a provision due to the lack of warranties claims in the
past. Some of our contracts include client acceptance clauses. In determining whether
revenue can be recognized, when an acceptance clause exists, we consider our history with
similar arrangements, the customers involvement in the progress, the existence of
other service providers and the payments terms.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Capitalized
software research and development costs. Development costs of software that is
intended for sale that were incurred after the establishment of technological feasibility
of the relevant product, are capitalized. Technological feasibility is determined when
detailed program design is completed and verified in accordance with the provisions of
the FASB Statement of Financial Accounting Standards No. 86 (SFAS 86). Software
development costs incurred before technological feasibility is established are charged to
the statement of operations as incurred net of participation of the office of the Chief
Scientist (OCS). Our policy on capitalized software costs determines the timing of our
recognition of certain development costs. In addition, this policy determines whether the
cost is classified as development expense or capitalized costs. Management is required to
use professional judgment in determining whether development costs meet the criteria for
immediate expense or capitalization. Amortization of capitalized software development
costs begins when the product is available for general release to customers. Annual
amortization is computed by the straight-line method, over the remaining useful life of
the product, currently over a period of 5 years, or based on the ratio of current gross
revenues to current and anticipated future gross revenues, whichever is higher. Our
failure to accurately predict the useful life of capitalized software could cause a
one-time amortization, which could adversely affect our operating results
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Impairment
of goodwill and intangible assets. Our business acquisitions resulted in goodwill and
other intangible assets. We periodically evaluate our goodwill, intangible assets, and
investments in affiliates for potential impairment indicators. Our judgments regarding
the existence of impairment indicators are based on legal factors, market conditions and
operational performance of our acquired businesses and investments.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
accordance with FASB Statement of Financial Accounting Standards No. 142 Goodwill
and Other intangible Assets (SFAS 142), effective January 1, 2002, indefinite life
intangible assets and goodwill are not amortized but rather subject to annual impairment
testing.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| | Goodwill
and intangible assets are tested for impairment by comparing the fair value of the
reporting unit with its carrying value. Fair value is generally determined using
discounted cash flows, market multiples and market capitalization. Significant estimates
used in the fair value methodologies include estimates of future cash flows, future short
term and long term growth rates, weighted average cost of capital and estimates of market
multiples of the reportable unit. If these estimates or their related assumptions change
in the future, we may be required to record impairment charges for our goodwill and
intangible assets. These write downs, if any, may have an adverse affect on our operating
results. Future events could cause us to conclude that impairment indicators exist and
that additional intangible assets associated with our acquired businesses are impaired.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
process of evaluating the potential impairment of goodwill is subjective and requires
significant judgment at many points during the analysis. In estimating the fair value of
the reporting unit for the purpose of our annual or periodic analysis, we make estimates
and judgments about the future cash flows of that reporting unit. Although our cash flow
forecasts are based on assumptions that are consistent with our plans and estimates we
are using to manage the underlying businesses, there is significant exercise of judgment
involved in determining the cash flows attributable to a reporting unit over its
estimated remaining useful life. In addition, we make certain judgments about allocating
shared assets to the estimated balance sheets of our reporting units. Changes in judgment
on these assumptions and estimates could result in a goodwill impairment charge. Any
resulting impairment loss could have a material adverse impact on our financial condition
and results of operations.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Income
taxes. Our income tax policy records the estimated future tax effects of temporary
differences between the tax bases of assets and liabilities and amounts reported in the
accompanying consolidated balance sheets, as well as operating loss and tax credit carry
forwards. We follow specific and detailed guidelines regarding the recoverability of any
tax assets recorded on the balance sheet and provide any necessary allowances as required
in our management opinion, in accordance with the provisions of FASB Statement of
Financial Accounting Standards No. 109 Accounting for Income Taxes. If we
fail to accurately predict our estimated tax and if we are required to pay higher taxes
than we anticipated, our results of operations could be seriously harmed.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Accounts
receivable. We maintain a conservative method to assure the collection of our
accounts receivable. Under this methodology, we periodically estimate the outstanding
amounts and deduct an allowance for receivables with a low collection certainty. When
there is a major deterioration of a customers credit worthiness, we make allowances
for doubtful accounts upon specific review of all outstanding invoices of such customer.
A relatively large portion of our revenue is generated from fixed-price-projects. We
recognize revenue according to the percentage of completion method, and rely on project
managers estimations in calculating that percentage. The customers payment
terms are usually based on milestones. Therefore the delay in actual collection may reach
4-6 months. The average debt duration is approximately 23 months. If we fail to
estimate accurately the recoverability of amounts due to us, our results of operations
could be adversely affected.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| | Derivative
Instruments. We have adopted Statement of Financial Accounting Standards SFAS No. 133
Accounting for Derivative Instruments and Hedging Activities(FAS 133).
Under the provisions of SFAS 133, all derivatives are recognized on the balance sheet at
their fair value. Changes in fair value are recognized periodically in earnings or
accumulated other comprehensive income within shareholders equity, depending on the
intended use of the derivative and whether the derivative has been designated by
management as a hedging instrument. Changes in fair value of derivative instruments not
designated as hedging instruments are recognized in earnings in the current period.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | We
use foreign currency options, forward exchange contracts and forward interest contracts
to assist in managing financial risks. We do not use derivative financial instruments for
speculative purposes. These instruments are recognized at fair value, with all changes in
fair value recorded in current period earnings, as these transactions have not been
designated as hedging instruments under FAS 133.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | We
have an embedded conversion features as part of the $3 million convertible debenture host debt
which is being marked to market and accounted in accordance with EITF 00-19Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled In, a Companys
Own Stock. In addition, we have convertible notes which consists an embedded put
option which is bifurcated from the host debt and is being recorded at fair value in
accordance with FAS 133.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Recently Issued
Accounting Pronouncements:

In
February 2006, the FASB issued FAS 155, Accounting for Certain Hybrid Financial
Instruments, an Amendment of FASB Statements No. 133 and 140". This statement
permits fair value measurement for any hybrid financial instrument that contains an
embedded derivative that otherwise would require bifurcation. This statement is effective
for all financial instruments acquired or issued after the beginning of an entitys
first fiscal year that begins after September 15, 2006. We are currently
evaluating the impact of this statement, if any, on our consolidated financial statements.

In
July 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes-an
interpretation of FAS 109. This financial interpretation clarifies the accounting
for uncertainty in income taxes, and prescribes a recognition threshold and measurement
attributes for the financial statement recognition and measurement of a tax position taken
or expected to be taken in a tax return. FIN 48 also provides guidance on various related
matters such as the derecognition, interest and penalties and disclosure. As applicable to
us, the interpretation prescribed by FIN 48 will be effective commencing January 1,
2007. We are currently evaluating the impact that the adoption of FIN 48 would have on our
consolidated financial statements.

In
September 2006, the FASB issued FAS 157, Fair Value Measurements. This
standard establishes a framework for measuring fair value and expands related disclosure
requirements; however, it does not require any new fair value measurement. As applicable
to us, this statement will be effective as of the year beginning on January 1, 2008.
We are currently evaluating the impact that the adoption of FAS 157 would have on our
consolidated financial statements.

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In
September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108, which expresses the
Staffs views regarding the process of quantifying financial statement misstatements.
The bulletin is effective as of the year beginning January 1, 2006. The
implementation of this bulletin had no impact on our consolidated financial statements.

In
February 2007, the FASB issued FAS 159, The Fair Value Option for Financial Assets
and Financial Liabilities. This standard permits entities to choose to measure many
financial assets and financial liabilities at fair value. Unrealized gains and losses on
items for which the fair value option has been elected are reported in earnings. As
applicable to us, this statement will be effective as of the year beginning
January 1, 2008. We are currently evaluating the impact that the adoption of FAS 159
would have on our consolidated financial statements.

In
September 2006, the FASB issued SFAS No. 158, Employers Accounting for
Defined Benefit Pension and Other Postretirement PlansAn Amendment of FASB
No. 87, 88, 106 and 132(R) (SFAS 158). SFAS 158 requires
that the funded status of defined benefit postretirement plans be recognized on the
balance sheet, and changes in the funded status be reflected in comprehensive income,
effective fiscal years ending after December 15, 2006. The adoption of this
statement did not have an impact on our consolidated financial statements.

In
December 2006, the FASB posted FASB Staff Position, or FSP, 00-19-2, Accounting
for Registration Payment Arrangements. This FSP specifies that the contingent
obligation to make future payments or otherwise transfer consideration under a
registration payment arrangement, whether issued as a separate agreement or included as a
provision of a financial instrument or other agreement should be separately recognized and
measured in accordance with FAS No. 5, Accounting for Contingencies. This
FSP further clarifies that a financial instrument subject to a registration payment
arrangement should be accounted for in accordance with other applicable GAAP without
regard to the contingent obligation to transfer consideration pursuant to the registration
payment arrangement. This FSP is effective immediately for registration payment
arrangements and financial instruments subject to those arrangements that were entered
into or modified subsequent to December 15, 2006. For registration payment
arrangements and financial instruments subject to those arrangements that were entered
into prior to December 15, 2006, the FSP is effective for fiscal years beginning
after December 15, 2006, and interim periods within those fiscal years. We will adopt
FSP 00-19-2 beginning January 1, 2007 and we are currently evaluating the potential
impact the adoption of this pronouncement will have on our consolidated financial
statements.

43

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In
November 2006, the FASB ratified EITF Issue No. 06-7, Issuers Accounting for a
Previously Bifurcated Conversion Option in a Convertible Debt Instrument When the
Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement No. 133,
Accounting for Derivative Instruments and Hedging Activities (EITF
06-7). At the time of issuance, an embedded conversion option in a convertible debt
instrument may be required to be bifurcated from the debt instrument and accounted for
separately by the issuer as a derivative under FAS 133, based on the application of EITF
00-19. Subsequent to the issuance of the convertible debt, facts may change and cause the
embedded conversion option to no longer meet the conditions for separate accounting as a
derivative instrument, such as when the bifurcated instrument meets the conditions of
Issue 00-19 to be classified in stockholders equity. Under EITF 06-7, when an
embedded conversion option previously accounted for as a derivative under FAS 133 no
longer meets the bifurcation criteria under that standard, an issuer shall disclose a
description of the principal changes causing the embedded conversion option to no longer
require bifurcation under FAS 133 and the amount of the liability for the conversion
option reclassified to stockholders equity. In addition, under the EITF, for
conversion of option for which the carrying amount has previously been reclassified to
shareholders equity, the issuer should recognize any unamortized discount remaining
at the date of conversion immediately as interest expense. EITF 06-7 should be applied to
all previously bifurcated conversion options in convertible debt instruments that no
longer meet the bifurcation criteria in FAS 133 in interim or annual periods beginning
after December 15, 2006, regardless of whether the debt instrument was entered into prior
or subsequent to the effective date of EITF 06-7. Earlier application of EITF 06-7 is
permitted in periods for which financial statements have not yet been issued. We are
currently evaluating the impact of this guidance on our consolidated financial statements.

Our Reporting Currency

A
substantial portion of our revenues and costs are denominated in United States dollars, or
dollars. The dollar is the primary currency of the economic environment in which
BluePhoenix operates. Thus the dollar is our functional and reporting currency.
Accordingly, monetary accounts maintained in currencies other than the dollar are
re-measured into dollars under the principles described in FASB Statement of Financial
Accounting Standards No. 52. Assets and liabilities have been translated at period-end
exchange rates. For non-dollar transactions reflected in the statements of operations, the
exchange rates at transaction dates are used. For consolidated companies whose functional
currency is other than the dollar, results of operations have been translated at
appropriately weighted average exchange rates. The exchange gains and losses arising from
these translations are included in the statement of income (loss).

Following
is a summary of the most relevant monetary indicators for the reported periods:

|For the year ended December 31, | Inflation rate in Israel | Devaluation of NISagainstthe US$ | Devaluation of euroagainst the US$
|------------------------------- | ------------------------ | -------------------------------- | ----------------------------------
|
|
|
|
|2004                            |                          |                                  |                                   
|2005                            |                          |                                  |                                   
|2006                            |                          |                                  |                                   

|A. | Operating
Results
|-- | -----------------

The
following table presents the percentage relationships of certain items from our
consolidated statement of operations, as a percentage of total revenues for the periods
indicated:

44

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# Statement of
Operations Dataas a Percentage of Revenues:

| |                                               | Year ended December 31,
| | --------------------------------------------- | -----------------------
|
|
|
|
| | Revenues                                      |                        
| | Cost of revenues                              |                        
| |                                               |                        
| | Gross profit                                  |                        
| | Software development costs                    |                        
| | Selling, general, and administrative expenses |                        
| |                                               |                        
| | Operating income                              |                        
| | Financial expenses, net                       |                        
| | Gain on realization of shareholdings          |                        
| | Other income, net                             |                        
| |                                               |                        
| | Income before taxes on income                 |                        
| | Income tax expense (income), net              |                        
| |                                               |                        
| |                                               |                        
| | Minority interest                             |                        
| | Equity in losses of affiliated companies, net |                        
| |                                               |                        
| | Net income                                    |                        
| |                                               |                        

# Years Ended December 31,
2006 and 2005

Revenues.           Revenues
increased 15% from $58.9 million in 2005 to $68.0 million in 2006. We           attribute
the revenue growth to two key factors. The main factor is the growing
          realization by major enterprises that are dependant on legacy core systems, of
          the inevitability of IT modernization for staying effective, competitive and
          efficient. In addition, there is a steadily growing awareness of BluePhoenix as
          a key leader in IT modernization with a significant installed base. We
          constantly update our suite of tools in order to enable a larger variety of
          languages, databases and platforms conversions. The price of a modernization
          project mainly depends on the number of lines of code to be converted, and is
          determined independently of the source and target platforms. As a result, the
          prices of our solutions do not fluctuate significantly.

The
table below presents the breakdown of our revenues based on the location of our customers
for the periods indicated:

| |                             | 2006 | 2005 | 2004
| | --------------------------- | ---- | ---- | ----
|
|
|
|
| | United States               |      |      |     
| | Europe (other than Denmark) |      |      |     
| | Denmark                     |      |      |     
| | Israel                      |      |      |     
| | Other                       |      |      |     
| |                             |      |      |     
| | Total                       |      |      |     

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Relationships
that we developed during previous years with several large European customers have matured
and started to generate a growing stream. As a result, our revenues in Europe grew from
$15.9 million in 2004 to $18.6 million in 2005 and $28.4 million in 2006.

In
order to compensate for the decrease in our revenues generated in North America, we plan
to expand more sales and marketing efforts in this market.

Cost
of revenues. Cost of revenues consists of salaries, travel costs relating to projects
and services rendered, amortization of capitalized software costs and fees paid to
independent subcontractors. Cost of revenues increased 12% from $25.4 million in 2005 to
$28.5 million in 2006. Cost of revenues as a percentage of revenues decreased 1.2% from
43.1% in 2005 to 41.9% in 2006. The decrease in cost of revenues was mainly due to the
expansion of our offshore centers, a process that is expected to continue in 2007. In
addition the degree of automation of our tools increases, the need for expert services
decreases, and as a result our direct expenses decrease.

The
total amount of amortization of intangible assets in 2006 was $7.1 million, compared to
$5.5 million in 2005. This increase was related to the general release of developed
modernization tools and the amortization of intangibles related to 2006 acquisitions.

Software
development costs. Software development costs, gross, consist of salaries and
consulting fees that we pay to professionals engaged in the development of new software
tools and related methodologies. Software development costs, net, consist of software
development costs, gross, less development grants and capitalized software costs.

Software
development costs, net, increased from $8.0 million in 2005 to $9.4 million in 2006. As a
percentage of revenues, software development costs, net remained at 14%.

Software
development costs, gross, increased from $16.3 million in 2005 to $17.4 million in 2006.
As a percentage of revenues, software development costs, gross decreased to 25.6% in 2006
compared to 27.7% in 2005.

In
the past few years, our development costs were attributed to the development of our unique
modernization suite of tools. Software development costs are charged to operations as
incurred, unless capitalized according to SFAS 86. In 2006, we capitalized software
development costs in an aggregate amount of $7.5 million compared to $8.0 million in 2005.
This decrease was primarily due to the market release of developed modernization tools and
reduced costs by using our offshore centers.

Selling,
general and administrative expenses. Selling, general and administrative expenses
consist primarily of wages and related expenses, travel expenses, third party and sales
people commissions, selling expenses, marketing and advertising expenses, rent, insurance,
utilities, professional fees, and depreciation. Selling, general and administrative
expenses increased from $21.6 million in 2005 to $22.1 million in 2006. During 2006, our
expanded marketing efforts lead to a significant growth in revenue and in number of new
signed deals during 2007.

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Financial
expenses, net. Financial expenses in 2006 were $3.5 million compared to $2.0 million
in 2005. The increase in financial expenses is mainly attributable to the issuance of
convertible notes in February 2006 and convertible debentures in March 2006. The
calculation of the discount amortization and the fair value adjustments of related
financial instruments resulted in non-cash financial expenses. The non-cash expenses
related to the convertible notes and debentures were $1.2 million in 2006 compared to
$556,000 in 2005. In addition, the increase in financial expenses was attributable to the
increase of the companys overall borrowings from banks.

Other
income, net.Other income, net in 2006 was $282,000 compared to $104,000 in 2005.
Other income in 2006 consists of dividend received from Steps Ventures, An Israeli venture
capital investment group, in which we hold 375,000 shares representing 3.75% of their
outstanding share capital.

Income
tax expense, net. In 2006, we had income from income tax, net of $282,000 compared to
an expense of $149,000 in 2005. The income in 2006 was related to the final settlement of
tax assessments with the Israeli Income Tax Authorities, which was partially offset by our
local taxes paid worldwide by our international subsidiaries.

Minority
interests in profits of subsidiaries. Minority interest in 2006 includes $204,000
representing the minority share in the profits of Mainsoft, $88,000 representing the
minority share in the profits of Liacom Systems and $25,000 representing the minority
share in the profits of Zulu Software Inc.

# Years Ended December 31,
2005 and 2004

Revenues.           Revenues
increased 3% from $57.2 million in 2004 to $58.9 million in 2005. This           increase
was mainly in the second half of 2005 and reflects the consolidation of           I-Ter
results. The price of a modernization project mainly depends on the number           of
lines of code to be converted, and is determined independently of the source
          and target platforms. As a result, the prices of our solutions do not fluctuate
          significantly.

The
increase in sales in Europe is partially attributable to our marketing efforts during
2005, which resulted in a 19% increase in revenues in Europe (including Denmark) in 2005
compared to 2004. In addition, the consolidation of I-Ter contributed to our annual
revenues growth in Europe. In the United States there was a decrease of 15% in revenues in
2005 compared to 2004. This decrease is mainly attributable to a delay in new orders from
the North American market during the first half of 2005.

Cost of revenues. Cost of revenues increased 4.6% from $24.3 million in 2004 to $25.4
million in 2005. Cost of revenues as a percentage of revenues increased 0.7% from 42.4% in
2004 to 43.1% in 2005. The increase in cost of revenues was caused by the increased amount
of amortization of intangible assets that reached technical feasibility during 2005. The
total amount of amortization of intangible assets in 2005 was $5.5 million, compared to
$3.1 million in 2004. This increase was mostly offset by a decline in salaries and project
related costs, due to the efficient usage of our offshore delivery centers.

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Software
development costs. Software development costs, gross, increased 4% from $15.6 million
in 2004 to $16.3 million in 2005. As a percentage of revenues, software development costs,
gross was not changed materially, 27.7% in 2005 compared to 27.3% in 2004.

In
the past few years, our development costs were attributed to the development of our unique
modernization suite of tools. Software development costs are charged to operations as
incurred, unless capitalized according to SFAS 86. In 2005, we capitalized software
development costs in an aggregate amount of $8.0 million compared to $7.1 million in 2004.
This increase was primarily due to the implementation of our strategy to expand our tool
offerings and increase the degree of automation of our tools. These factors are important
in order to maintain our leadership position in the market and perform profitable
projects.

Selling,
general and administrative expenses. Selling, general and administrative expenses
increased from $21.4 million in 2004 to $21.6 million in 2005. During 2005, our management
members devoted significant marketing efforts in order to further expose the
Companys suite of tools to potential customers and partners.

Financial
income (expenses), net. Financial expenses in 2005 were $2.0 million compared to
$882,000 in 2004. A portion of the increase in financial expenses is due to the issuance
of convertible debentures in March 2004, which was partially included in financial
expenses in 2004 and fully accounted for in the first quarter of 2005, when a registration
statement covering the underlying shares became effective. In addition, the increase in
financial expenses is attributable to (i) the increase of the companys overall
borrowings from banks, and (ii) the devaluation of the euro conversion rate compared to
the dollar in 2005 by 13.3%, as compared to a 7.4% increase in the euro conversion rate in
2004.

Gain
on realization of shareholdings. There was no gain on realization of shareholdings in
2005. Gain on realization of shareholdings in 2004 was $112,000. This gain results from a
sale of ordinary shares of Cicero Inc. was $171,000. This gain was partially offset by a
loss of $59,000 resulted from transaction-related costs with respect to the sale of our
shareholdings in Tesnet  Software Testing Ltd., or Tesnet. The sale of Tesnets
shares was for cash consideration of $2.8 million.

Other
income, net.Other income, net in 2005 was $104,000 compared to $975,000 in 2004.
Other income in 2004 consists primarily of a $703,000 dividend received from Steps
Ventures.

Income
tax expense. In 2005, we had an income tax expense of $149,000 compared to $260,000 in
2004. Due to tax losses carried forward in Israel and in several other locations, our
total tax expense is composed of the net aggregate expense of local taxes paid worldwide
by our international subsidiaries.

Share
in losses of affiliated companies, net. In 2004, share in losses of affiliated
companies, net, was $516,000. Share in losses of affiliated companies in 2004 was mainly
attributable to $69,000 representing our share in the losses of Intercomp, and $455,000
representing our share in the losses of MultiConn Technologies. In 2005, these two
affiliates were consolidated in our result of operations, and therefore no equity in
losses of affiliated companies was recorded.

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Minority
interests in profits of subsidiaries. Minority interest in 2005 includes $137,000
representing the minority share in the profits of Mainsoft, and $2,000 representing the
minority share in the profits of Liacom Systems.

|B. | Liquidity
and Capital Resources
|-- | -------------------------------

# How We Have Financed Our Business

In
1997, we consummated two public offerings, and received net proceeds of $33.9 million
after deducting underwriting discounts and commissions and offering expenses.

On
March 30, 2004, we completed a $5 million private placement to institutional investors.
Under the terms of this transaction as amended on February 18, 2005, we issued to the
institutional investors convertible debentures due in 2007, bearing interest at a rate of
six months LIBOR paid quarterly. Pursuant to our agreement with the institutional
investors, in March 2006, the institutional investors exercised their right to purchase
from us additional convertible debentures and warrants for an aggregate purchase price of
$3 million. Those debentures are due in 2009.

As
of March 22, 2007, $4.4 million principal amount of the debentures were converted into
929,475 BluePhoenix ordinary shares. For more information regarding the private placement,
see  Contractual Commitments and Guarantees.

In
February 2006, we completed an underwritten public offering in Israel of series A
convertible notes in an aggregate principal amount NIS 54.0 million that were equal at
that time to approximately $11.5 million . The price of the notes as determined in the
offering was 98% of the principal amount of the notes, and the gross proceeds from the
offering were $11.2 million. The notes bear an interest at a rate of LIBOR 3 months +1.5%
per annum, payable every 3 months beginning on May 1, 2006, with the last payment to be
made on February 1, 2011. The principal of the notes is payable in four equal annual
installments on February 1 of each of 2008 through 2011. Under certain terms, we may call
for an early redemption of the notes, after February 1, 2008. The notes are convertible
into ordinary shares of BluePhoenix at a conversion rate of one ordinary share per NIS 26
($6.15) principal amount of notes, subject to adjustments. Holders may convert their notes
into BluePhoenixs ordinary shares on any trading day, beginning on the date the
notes were first listed for trading and until the close of trading on January 16, 2011,
except for certain specified days. The convertible notes are not secured.

As
of March 22, 2007, NIS 402,000 principal amount of the notes (approximately $96,000) were
converted into 15,474 BluePhoenix ordinary shares.

The
notes are traded on the TASE. The notes and the shares underlying the notes have not been
registered under the Securities Act, and may not be offered or sold in the United States
or to U.S. persons, absent registration or an applicable exemption from registration
requirements.

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We
have entered into credit facilities with Bank Discount LeIsrael Ltd., Bank
HaPoalim Ltd. Bank Leumi LeIsrael Ltd. and the First International Bank Ltd.,
of up to an aggregate of $33.5 million. The aggregate amount outstanding under these
credit facilities as of December 31, 2006 was $22.2 million, and as of March 22, 2007 was
$22.1 million. We used these credit facilities to finance certain acquisitions, to give
guarantees, and for interim financing, in accordance with our cash requirements. A portion
of the credit lines were used in 2006 to finance the acquisitions of CodeStream and Zulu.
See item 4 B Investment and Acquisitions. These credit facilities provide for
loans in various currencies and bear various interest rates. In connection with these
credit facilities extended to us by these banks, we are committed to certain covenants
related to our operations, such as:

| |  | maintaining
a minimum level of shareholders' equity of no less than 40% of our total assets and no
less                   than $40 million;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------

| |  | maintaining
a level of annual operating income before depreciation and amortization of no less than
$5                   million; and
| | - | -------------------------------------------------------------------------------------------------------------------------------------

| |  | maintaining
a ratio of our bank liabilities to current assets, excluding other current assets, of no
more than 55%.
| | - | -------------------------------------------------------------------------------------------------------------------

To
date, we have met all such covenants.

On December
31, 2006, we had cash and cash equivalents (including marketable securities) of $12.7
million and working capital of $17.9 million. On December 31, 2005, we had cash and cash
equivalents of $10.8million and working capital of $4.5 million.

Net
cash provided by operating activities was $10.0 million in 2006 compared to $5.2 million
in 2005. Cash provided by operating activities in 2006 and 2005 was primarily the result
of add-backs from depreciation and amortization. This was partially offset by the changes
in operating assets and liabilities, net.

Typical
modernization projects, which deploy our solutions, are long-term projects, and therefore,
payment for these projects or a substantial portion of our fees may be delayed until the
successful completion of specified milestones and customer acceptance for the completed
work. During 2004, we mutually agreed with a customer, to terminate a contract. The
contract was accounted for under the percentage of completion method. As a result, we
recorded a loss of $400,000 in the first quarter of 2004. The payment of our fees is
generally dependent upon customer acceptance of the completed work, and our ability to
collect the fees. Further, although the timing of receipt of our fees varies, we incur the
majority of our expenses on a current basis. As a result, a delay in the collection of our
fees could result in cash flow shortages.

Capital Expenditures

Our
capital expenditures were $676,000 in 2006 and $700,000 in 2005. Our capital expenditures
in these years related primarily to purchases of computers and related equipment required
to support our software development activities. In 2005, we invested $370,000 in other
companies.

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In
December 2006, we purchased the activities of CodeStream for a consideration of $10.2
million. For more information about the CodeStream transaction, see Item 4.B.
Business Overview  Investments and Acquisitions CodeStream.

In
the last three years, we did not repurchase any shares under our buy-back programs. As of
December 31, 2006, we had repurchased 1,870,565 of our ordinary shares under our buy-back
programs, for an aggregate of approximately $14.7 million. In January 2006, we sold an
aggregate of 136,000 of the shares held by one of our subsidiaries to Israeli
institutional investors in Israel, for aggregate consideration of approximately $534,000.
In February 2006, we sold 86,971 shares held by one of our subsidiaries to Outlook Systems
Ltd.; see Item 4.B. Business Overview  Investments and Acquisitions 
Outlook. Under our buy-back programs, we may purchase our shares from time to time,
subject to market conditions and other relevant factors affecting us. Under the Companies
Law, the repurchased shares do not confer upon our subsidiaries any voting rights
(although they entitle their holders to participation rights upon distribution). The first
buy-back program adopted in May 1998 enables us to purchase our shares, through a
subsidiary, utilizing up to $5.0 million. Under the second buy-back program adopted in
September 1998, and amended in May 1999, we may purchase, through a subsidiary as a
trustee, up to an additional 2,000,000 ordinary shares. Under the two plans we may acquire
an additional 854,455 shares at the current stock price. The closing price of our ordinary
shares as quoted on the Nasdaq Global Market on March 22, 2007 was $6.84. Under the
agreement we entered into in connection with the private placement in March 2004, we are
restricted to use only up to $200,000 for the repurchase of our shares, as long as 20% or
more of the debentures are outstanding.

We
believe that cash generated from operations together with existing sources of liquidity
and cash flow, will be sufficient to meet our anticipated cash needs for at least the next
18 months.

# Contractual Commitments
and Guarantees

Convertible
Debentures Issued in a Private Placement to Institutional Investors

On
March 30, 2004, we completed a $5 million private placement of convertible debentures and
warrants to four institutional investors. On February 18, 2005, the institutional
investors and we amended certain terms of the transaction. Pursuant to the amended
agreements, the debentures are due in 2007 and bear interest at a rate equal to the
six-month LIBOR, paid quarterly in cash or in a number of BluePhoenix ordinary shares, at
our discretion. The debentures are convertible into BluePhoenixs ordinary shares at
a conversion rate of $5.25 per ordinary share, subject to (i) adjustment for stock
dividends, stock splits, recapitalization and other similar events; and (ii) anti-dilution
adjustments. Following an event of adjustment in January 2006, the conversion rate of the
debentures was adjusted to $5.24 per ordinary share. The conversion rate with respect to
payments of interest on the debentures will be equal to 90% of the volume weighted average
price of our ordinary shares on the Nasdaq Global Market during the 20 trading days
preceding the date of payment of interest. In the event the volume weighted average price
per ordinary share (as calculated in the preceding sentence) for any 20 consecutive
trading days exceeds $6.55, then we may force the holders of the debentures to convert any
or all of the principal amount of the debentures held by them as of such date, subject to,
among other things, our having an effective resale registration statement at such time for
the resale of the ordinary shares underlying the debentures. As of March 22, 2007,
subsequent to conversion of some of the debentures, we issued to the investors 262,808
ordinary shares.

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In
addition to the debentures, the institutional investors were issued warrants to purchase
up to 285,714 BluePhoenix ordinary shares at an exercise price of $6.50 per share, subject
to adjustments similar to those pertaining to the conversion price of the debentures. The
warrants are exercisable during a 5 years period commencing in September 2004.

Pursuant
to our agreement with the institutional investors, in March 2006, three of the investors
exercised their right to purchase from us additional debentures and warrants. Accordingly,
we issued to the investors debentures at an aggregate purchase price of $3 million on the
same terms as the initial debentures, except that the conversion price is $4.50 per share
and due in 2009. As of March 22, 2007, subsequent to conversion of the debentures,
we issued to the investors 666,667 ordinary shares. In addition, the institutional
investors were issued additional warrants on the same terms as the initial warrants, to
purchase an aggregate of up to 200,000 of our ordinary shares. The warrants are
exercisable during a 5 years period commencing in September 2006.

As
agreed with the investors, we registered the shares underlying the debentures and warrants
for resale under an effective registration statement.

Series
A Convertible Notes Offered to the Public in Israel

In
February 2006, we completed an underwritten public offering in Israel of series A
convertible notes in an aggregate principal amount of NIS 54.0 million that were equal at
that time to approximately $11.5 million. Interest on the notes is LIBOR 3 months +1.5%
per annum. The interest is payable every 3 months beginning on May 1, 2006, with the last
payment to be made on February 1, 2011. The principal of the notes is payable in four
equal annual installments on February 1 of each of 2008 through 2011. The notes are
convertible into BluePhoenixs ordinary shares at a conversion rate of one ordinary
share per NIS 26 ($6.15) principal amount of notes. The notes are traded on the TASE. For
more information regarding the series A convertible notes, see Item 5.B. Liquidity
and Capital Resources-How Have We Finances Our Business.

Under
funding agreements, three of our subsidiaries have entered into with the Office of the
Chief Scientist (OCS), these subsidiaries are obliged to pay royalties to the OCS at a
rate of 3% on sales of the funded products, up to 100% of the dollar-linked grant received
in respect of these products from the OCS. As of December 31, 2006, the aggregate amount
of grants received by our subsidiaries from the OCS was $2.5 million.

In
the first quarter of 2004, the Singapore-Israel Industrial Research and Development
Foundation agreed to provide one of our wholly owned subsidiaries together with a company
incorporated in Singapore, financing for the development of a Java report generator
software tool. Accordingly, the foundation agreed to award our subsidiary up to $100,000
payable according to an agreed upon schedule. As of March 22, 2007, we received $45,000 of
the grant. The grant is required to be repaid in installments based on sales of the funded
software up to the amount of the grant.

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Our
subsidiary, I-Ter, is entitled to funds to develop Easy4Plan product, from the Ministry of
Production in Italy. Easy4Plan is a workflow management tool designed for ISO9000
companies. Approximately 30% of the funds are a grant, and the balance is an 8-year loan
to be repaid by I-Ter. The loan bears a minimal annual interest. The development term
ended in September 2006. Pending the final approval of the Ministry of Production, we
anticipate that during 2007 I-Ter will receive a total aggregate amount of approximately
$650,000.

We
are obligated to pay to Formula management fees in an annual amount equal to 3% of our
revenues, but no more than the NIS equivalent of $180,000. For more information see
Item 7. Major Shareholders and Related Party Transactions  Related Party
Transactions  Management Agreement with Formula.

Under
agreements between us and certain of our customers, we undertook to provide such customers
bank guarantees for the assurance of performance of our obligations under our agreements
with such customers. As of March 22, 2007, there are outstanding bank guarantees on our
behalf for our customers in the aggregate amount of $420,000.

We
are committed under operating leases for rental of office facilities, vehicles and other
equipment for the years 2007 until 2011. Annual rental fees under current leases are
approximately $3.1 million, and are expected to remain at this level for each of the next
three years. In connection with the office leases, we issued bank guarantees of $107,000
in the aggregate.

We
entered into an undertaking to indemnify our office holders in specified limited
categories of events and in specified amounts, subject to certain limitations. For more
information, see Item 7.B. Related Party Transactions  Indemnification of
Office Holders.

Effective Corporate Tax
Rates

In
1996, 1997 and 1998, certain of our operations were granted approved
enterprise status under the Law for the Encouragement of Capital Investments 
1969, known as the Investments Law. If we comply with all requirements, we shall be
eligible for certain tax benefits with respect to these operations, for the first seven
years in which they generate taxable income. Undistributed income derived from our
approved enterprise programs will be exempt from corporate tax for a period of two years
after we have taxable income, and will be subject to a 25% corporate tax rate for the
following five years. We completed the tax exemption period of some of our qualified
approved enterprise operations and, therefore, these operations are subject to
a 25% income tax commencing 1999. If the percentage of our share capital held by foreign
shareholders exceeds 25%, future approved enterprises would qualify for reduced tax rates
for an additional three years, after the seven years mentioned above. However, we cannot
assure you that we will obtain additional approved enterprise status for our
operations, or that the provisions of the Investments Law will not change, or that the
above-mentioned shareholding portion will be reached or maintained for each subsequent
year.

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On
January 1, 2003, Israels tax laws underwent a significant tax reform (Amendment 132
to the Income Tax Ordinance (New Version)  1961). The legislation broadened the
categories of taxable income, and reduced the tax rates imposed on employment income.
Among the key provisions of this legislation were (i) changes that may result in the
imposition of taxes on dividends received by an Israeli company from its foreign
subsidiaries; and (ii) the introduction of the controlled foreign corporation concept
according to which an Israeli company may become subject to Israeli taxes on certain
income of a non-Israeli subsidiary if the subsidiarys primary source of income is
passive income (such as interest, dividends, royalties, rental income or capital gains).
An Israeli company that is subject to Israeli taxes on the income of its non-Israeli
subsidiaries will receive a credit for income taxes paid by the subsidiary in its country
of residence.

On
January 1, 2006, an additional tax reform has been taken place relating primarily to
profits from investments. The main goal of the reform was to unify the tax rates
applicable to profits from investments, such as interest, capital gains and dividends. In
addition, under the new reform, the tax rates applicable to companies were reduced to 31%
in 2006, 29% in 2007, 27% in 2008, 26% in 2009 and 25% in 2010.

Our
international operations are taxed at the local effective corporate tax rate in the
countries of our subsidiaries residence. We believe that in the future we will
derive an increasing percentage of our income from operations outside of Israel and that,
accordingly, our effective tax rate may increase. However, we expect that this increase
will be offset by carried forward accumulated losses of consolidated companies. As a
result, we anticipate that our net effective tax rate in the foreseeable future shall be
lower than 25%.

|C. | Research
and Development, Patents and Licenses
|-- | ----------------------------------------------

For
a description of our research and development activities, see "Item 4.B. Business
Overview - Research and Development."

For
information concerning our intellectual property rights, see Item 4.B. Business
Overview  Intellectual Property.

|D. | Trend
Information
|-- | -----------------

We
have been affected by global economic changes, in particular the sharp decline in 2001 and
2002, in capital spending in the IT sector and the overall business slowdown in North
America and Europe, as well as in Israel. Uncertainties in the North American and European
markets have influenced the purchasing patterns of leading software developers who delayed
their planned orders and caused developers to reduce the amount of their planned license
commitment. These changes in purchasing patterns in the IT industry directly affect our
operating results. In 2006, we generated $4.7 million net income from our operations.
However, in 2002 and 2001 we had a net loss of $3.6 million and $15.0 million,
respectively. The net loss in 2002 and 2001 was a reversal from prior years in which we
had net income. We cannot know how the economic conditions will continue to affect our
business. As we continue to market new products and penetrate international markets, we
expect our selling, general and administrative expenses to continue to be relatively high.

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|E. | Off-Balance
Sheet Arrangements
|-- | ------------------------------

For
information relating to contingent consideration in certain acquisitions, see Item
4.B. Business Overview  Investments and Acquisitions  CodeStream, Outlook,
I-Ter, CePost.

|F. | Tabular
Disclosure of Contractual Obligations
|-- | ---------------------------------------------

The
following table summarizes our contractual obligations and commitments as of December 31,
2006:

|                            | Payment due by period
|--------------------------- | ---------------------
|
|
|
|
|Long term debt obligations  |                      
|Operating lease obligations |                      
|                            |                      
|Total                       |                      

The
above table does not include interest payments and royalties that we may be required to
pay to the OCS and that may reach, in the aggregate, as of December 31, 2006, $2.5
million. For more information about grants received from the OCS, see Item 4.B.
Business Overview  Research and Development. We are unable to reasonably
estimate the amounts that we will eventually be required to pay to the OCS, if at all, and
the timing of such payments, since these payments depend on our ability to sell products
based on the OCS-funded technologies and the timing of such sales, if any.

|G. | Safe
Harbor
|-- | -----------

The
safe harbor provided in Section 27A of the Securities Act and Sections 21E of the Exchange
Act shall apply to forward-looking information provided in Items 5.E and F.

# ITEM 6. DIRECTORS,
SENIOR MANAGEMENT, AND EMPLOYEES

|A. | Directors
and Senior Management
|-- | -------------------------------

The
following table describes information about our executive officers and directors as of
March 22, 2007.

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|Name                     | Age |  | Position                         
|------------------------ | --- |  | ---------------------------------
|
|
|
|
|Gad Goldstein            | 48  |  | Chairman of the Board            
|Arie Kilman              | 54  |  | Chief Executive Officer, Director
|Iris Yahal               | 46  |  | Chief Financial Officer, Director
|Shai Beilis              | 58  |  | Director                         
|Naamit Salomon           | 42  |  | Director                         
|Aaron Crystal            | 63  |  | Director                         
|Gur Shomron (1)          | 54  |  | Director                         
|Guy Bernstein            | 39  |  | Director                         
|Michael Chill (1)        | 40  |  | Director                         
|Amira Berkovitz-Amir (1) | 40  |  | Director                         

---

| | (1)
An outside director
| | -----------------------

Gad
Goldstein has served as a chairman of our board of directors since April 1998. Mr.
Goldstein was the vice president of Formula from 1985 through 1995, and was appointed
president and chief executive officer of Formula in 1995. Mr. Goldstein served as a
director of Formula from January 1985 through December 2006. He is also a director of
other companies within the Formula Group, including Matrix IT Ltd., Magic Software
Enterprises Ltd., or Magic, and Sapiens International Corporation N.V., all of which are
publicly traded companies. Mr. Goldstein also serves as a director of Formula Vision
Technologies (F.V.T.) Ltd. Mr. Goldstein holds a BA in economics and an MA in business
administration, both from Tel Aviv University.

Arie
Kilmanhas served as our chief executive officer since May 2003. Mr. Kilman has also
served as president and chief executive officer of BluePhoenix Solutions B.V. since its
inception in October 2001. Mr. Kilman previously served as the president of Liraz, which
he founded in 1984, and managed since then. From 1998 to July 2000, Mr. Kilman served as
chief executive officer of Level 8. Mr. Kilman holds a BA degree in economics and computer
science from New York University.

Iris
Yahal has served as one of our directors since January 1, 1999 and as our chief
financial officer since October 1995. In addition, Ms. Yahal served as the controller of
several other Formula subsidiaries until December 1996. From 1991 until 1996, Ms. Yahal
served as the controller of Transtech Control Ltd., a subsidiary of Formula. Prior to
1991, Ms. Yahal worked as an auditor with Wallenstein and Co., a public accounting firm.
Ms. Yahal holds a BA in accounting and an MA in business administration, both from Tel
Aviv University, and is a certified public accountant in Israel.

Shai
Beilis served as chairman of our board of directors from December 1995 until April
1998 and as vice chairman of our board of directors from April 1998 until November 1999.
Mr. Beilis continues to serve as one of our directors. Mr. Beilis currently serves as
chairman and chief executive officer of Formula Ventures Ltd., a venture capital fund
manager. Mr. Beilis also served as a director of Formula from December 1997 until February
2005. From July 1993 until the beginning of 1995, Mr. Beilis served as the managing
director of Clal Computers and Technology Ltd., an Israeli information technology company
traded on TASE. Mr. Beilis holds a B.Sc. in mathematics and economics from the Hebrew
University in Jerusalem (cum laude) and an MA in computer science from the Weizmann
Institute of Science.

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Naamit
Salomonjoined our board of directors in December 2004. Ms. Salomon has served as vice
president, finance of Formula since August 1997. Ms. Salomon also serves as a director of
Magic and Sapiens International Corporation N.V. From 1990 through August 1997, Ms.
Salomon was a controller of two privately held companies in the Formula Group. Ms. Salomon
holds a BA in economics and business administration from Ben Gurion University and an LLM
from Bar-Ilan University.

Aaron
Crystal founded our company (previously named Crystal System Solutions Ltd.) in 1987,
and served as our chief executive officer through 1996 and president through March 2005.
Mr. Crystal has served as one of our directors since our formation. Between November 1999
and December 2004, he also served as vice chairman of our board of directors. From 2004,
Mr. Crystal has served as chairman of the board of a privately held software company,
Cogniview Ltd. From 1983 to 1987 Mr. Crystal was vice president, technical support of
Mehish Computer Services.

Gur
Shomron joined our board of directors and appointed as a member of our audit committee
in July 2005. Mr. Shomron serves as the chairman of the board of directors of Fidelis
Diagnostics Inc. since 2004. Prior to that, Mr. Shomron served as Venture Partner at
StageOne VC fund. Mr. Shomron is also a management consultant for Bet Israel 101 Ltd. and
serves as a director of our subsidiary, Mainsoft, and of several other privately-held high
technology companies.

Guy
Bernstein joined our board of directors in December 2006. Mr. Bernstein is the chief
executive officer and member of the board of directors of Emblaze Ltd., a major
shareholder of Formula. Prior to that, from April 2004, Mr. Bernstein has served as chief
financial officer of Emblaze. Between 1999 and 2004, Mr. Bernstein served as chief
financial and operations officer of Magic. He also acted as the interim chief executive
officer for subsidiaries of Magic, MSE Israel Ltd. and Coretech Consulting Group. From
1994 to 1997, Mr. Bernstein acted as senior manager at Kost Forer Gabbay & Kasierer, a
member of Ernst & Young Global. Mr. Bernstein holds a BA in accounting and economics
from Tel-Aviv University and is a certified public accountant in Israel.

Michael
Chillhas served as one of our outside directors and a member of our audit committee
since July 2003. From July 2005, Mr. Chill has served as Co-head of the Direct Investments
at Paramount Biocapital Asset Management Inc, a venture capital hedge fund and broker
dealer. Prior to that, Mr. Chill served as an analyst and independent advisor to various
high technology companies and venture capital firms both in Israel and the United States.
During 2000 and the first half of 2001, Mr. Chill served as the president and head of
investment banking department at Jerusalem Global Ltd., a venture capital and investment
banking firm. Prior to that, from 1999, Mr. Chill served as a managing director in the
technology investment banking group at Gruntal and Co. Mr. Chill holds a B.S. in
accounting from the Sy Syms School of Business at Yeshiva University and an MBA from the
Columbia Business School.

Amira
Berkovitz -Amir has served as one of our outside directors and as a member of our
audit committee since December 2004. From March 2007, Ms. Berkovitz-Amir is the director
of finance of the Baruch Padeh Medical Center, Poriya. Until October 2005, Ms.
Berkovitz-Amir served as vice president, finance of Of-Tov Products (2001) Ltd., a
manufacturer in the food industry and a member of Osem Industries Group. Previously, Ms.
Berkovitz-Amir served as vice president, finance and controller of Pri-Hagalil Industries,
a manufacturer in the food industry. Ms. Berkovitz-Amir holds a BA degree in economics and
accounting and an MA in business administration, both from the Hebrew University. Ms.
Berkovitz-Amir is a certified public accountant in Israel.

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|B. | Compensation
|-- | ------------

In
2006, we paid to our outside directors and executive officers aggregate remuneration of
approximately $642,227. This amount includes bonuses and amounts set aside or accrued to
provide pension, social security or similar benefits but does not include amounts expended
by us for automobiles made available to our officers and expenses (including business
travel, professional and business association dues and expenses) reimbursed to officers.
Under Israeli law, we are not required to disclose, and have not otherwise disclosed, the
compensation of our senior management and directors on an individual basis.

The
aggregate remuneration set forth in the foregoing paragraph does not include amounts we
paid to Formula under the terms of a management agreement, as consideration for management
services rendered to us by certain directors designated by Formula. These directors
currently include Gad Goldstein, Guy Bernstein and Naamit Salomon. See Item 7.B. Related Party
Transactions.

We
maintain written employment agreements with Arie Kilman and Iris Yahal. The employment
agreements are not for a specific term and we may terminate any of them upon prior notice
of between three and six months. If we terminate any of these employment agreements, we
will have to pay the usual severance pay required under Israeli law for all employees. The
directors are not entitled to any other benefits upon termination. These agreements
provide for annual base salaries and other benefits like vacation, sick leave, provision
of automobiles, insurance contributions, and non-compete and confidentiality agreements.
The agreements also entitle Mr. Kilman and Ms. Yahal to bonuses based on achieving targets
set by our board of directors.

Mr.
          Kilman, in his former position as Lirazs chairman of the board of
          directors was granted by Liraz, in May 2002, a loan in an amount equal to
          approximately $300,000, linked to the Israeli consumer price index, and bearing
          annual interest at a rate of 4%. Under the terms of the loan, the loan was
          repaid to Liraz in four equal annual installments, the last one of which was
          made in 2006. Mr. Kilman has fully complied with all loan payment obligations
          under the loan agreement.

|C. | Board
Practices
|-- | ---------------

Pursuant
to our articles of association, directors are elected at a general meeting of our
shareholders by a vote of the holders of a majority of the voting power represented at the
meeting. Additional directors may be elected between general meetings by a majority of our
directors. Our board is comprised of 10 persons, of which 3 have been determined to be
independent within the meaning of the applicable NASDAQ requirements. Two of these
independent directors also serve as outside directors mandated under Israeli law and
subject to additional criteria to help ensure their independence. See Outside
Directors, below. Each director, except for the outside directors, holds office
until the next annual general meeting of shareholders. Officers are appointed by our board
of directors.

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Our
board of directors has appointed an option committee, comprised of Messrs. Gad Goldstein,
Shai Beilis and Amira Berkovitz-Amir. The option committee is responsible for granting
options to employees.

The
compensation of our executive officers is determined by independent members of our board
of directors. The compensation of officers that requires the approval of the audit
committee or any other additional approval under applicable law, is also brought for such
entities additional approval.

Companies
trading on The NASDAQ Stock Market are generally required to have a majority of their
board members be independent. We are exempt from this requirement under the
controlled company exemption because more than 50% of our voting power is held
by Formula.

Outside Directors

Under
the Companies Law, 1999, referred to as the Companies Law, companies incorporated under
the laws of Israel whose shares have been offered to the public in or outside of Israel,
are required to appoint at least two outside directors. The Companies Law provides that a
person may not be appointed as an outside director if the person or the persons
relative, partner, employer or any entity under the persons control, has, as of the
date of the persons appointment to serve as outside director, or had, during the two
years preceding that date, any affiliation with the company or any entity controlling,
controlled by or under common control with the company. The term affiliation
includes:

| |  | an
employment relationship;
| | - | ---------------------------

| |  | a
business or professional relationship maintained on a regular basis;
| | - | ----------------------------------------------------------------------

| |  | control;
and
| | - | ------------

| |  | service
as an office holder.
| | - | ----------------------------

No
person may serve as an outside director if the persons position or other business
activities create, or may create a conflict of interest with the persons
responsibilities as an outside director or may otherwise interfere with the persons
ability to serve as an outside director or if the person is an employee of the Israel
Securities Authority or of an Israeli stock exchange. If, at the time of election of an
outside director, all other directors are of the same gender, the outside director to be
elected must be of the other gender. Outside directors are elected by a majority vote at a
shareholders meeting, provided that either:

| | (1) | the
majority of shares voted at the meeting, including at least one-third of           the
shares of non-controlling shareholders or their representatives voted at the
          meeting, vote in favor of election; or
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | the
total number of shares of non-controlling shareholders voted against the
               election of the outside director does not exceed one percent of the
aggregate                voting rights in the company.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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Pursuant
to the Companies Law, all outside directors must have financial and accounting expertise
or professional qualifications, and at least one outside director must have financial and
accounting expertise. The terms financial and accounting expertise and
professional qualifications have been defined in regulations promulgated under
the Companies Law.

The
initial term of an outside director is three years and may be extended for an additional
three years. At present, Mr. Michael Chill and Ms. Amira Berkovitz-Amir serve as our
outside directors, Mr. Chill to hold office until July 2009 and Ms. Berkovitz-Amir until
December 2007. Under a recent amendment to the Israeli Companies Regulations (Alleviation
for Public Companies Whose Shares are Listed on a Stock Exchange Outside of Israel) 2000,
dual listed companies, like us, may re-appoint an outside director for an additional
three-year term, above the maximum six-year term permitted under the Companies Law, if the
audit committee and the board of directors confirm that due to the expertise and special
contribution of the outside director to the work of the board and its committees, his
re-appointment is in the best interests of the company.

Each
committee exercising the powers of the board of directors is required to include at least
one outside director. However, the audit committee should include all the outside
directors.

An
outside director is entitled to compensation as provided in regulations promulgated under
the Companies Law and is otherwise prohibited from receiving any compensation, directly or
indirectly, in connection with services provided as an outside director. We compensate our
two outside directors in accordance with regulations promulgated under the Companies Law.

Qualifications of Other
Directors

Under
the Companies Law, the board of directors of a publicly traded company is required to make
a determination as to the minimum number of directors who must have financial and
accounting expertise according to criteria that is defined in regulations promulgated
under the Companies Law. In accordance with the Companies Law, the determination of the
board should be based on, among other things, the type of the company, its size, the
volume and complexity of its activities and the number of directors. Based on the
foregoing considerations, our board determined that the number of directors with financial
and accounting expertise in our company shall not be less than two.

# Audit Committee

The
Companies Law requires public companies to appoint an audit committee, comprised of at
least three directors, which must include all of the companys outside directors. The
chairman of the board of directors, any director which is employed or provides services to
the company, and a controlling shareholder or any relative of a controlling shareholder,
may not be a member of the audit committee.

In
addition, under applicable NASDAQ rules, we are currently required to have at least three
independent directors and to maintain an audit committee, whose members are independent of
management. Our outside directors qualify as independent directors under the applicable
NASDAQ rules and those of the Securities and Exchange Commission. We have established an
audit committee, consisting of our two outside directors, Mr. Michael Chill and Ms. Amira
Berkovitz-Amir, as well as Mr. Gur Shomron, who is considered independent
under the applicable NASDAQ rules. The board has determined that both Michael Chill and
Amira Berkovitz-Amir are audit committee financial experts as defined by
applicable SEC regulations.

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Under
the Companies Law, the audit committee is responsible for overseeing the business
management practices of the company in consultation with the companys internal
auditor and the independent auditor, making recommendations to the board to improve such
practices and approving related party transactions as required by the Companies Law. In
accordance with the Sarbanes-Oxley Act and NASDAQ requirements, our audit committee is
directly responsible for the appointment, compensation and oversight of our independent
auditors. In addition, the audit committee is responsible for assisting the board in
monitoring our financial statements and the effectiveness of our internal controls. We
have adopted a formal audit committee charter that we have implemented, embodying these
responsibilities. The audit committee reviews and reassesses the adequacy of the audit
committee charter on an annual basis.

Internal Auditor

Under
the Companies Law, the board of directors appoints an internal auditor, nominated by the
audit committee. The role of the internal auditor is to examine, among other matters,
whether the companys actions comply with the law and orderly business procedure.
Under the Companies Law, the internal auditor may be an employee of the company but not an
office holder, or an interested party (defined as a holder of 5% or more of the voting
rights in the company or of its issued share capital, the chief executive officer of the
company or any of its directors, or a person who has the authority to appoint the
companys chief executive officer or any of its directors), or a relative of an
office holder or of an interested party. In addition, the companys external auditor
or its representative may not serve as the companys internal auditor.

Approval of Certain
Transactions under the Companies Law

The
Companies Law codifies the fiduciary duties that office holders, including
directors and executive officers, owe to a company. An office holders fiduciary
duties consist of a duty of care and a duty of loyalty. The duty of loyalty includes (i)
avoiding any conflict of interest between the office holders position in the company
and his personal affairs; (ii) avoiding any competition with the company; (iii) avoiding
exploiting any business opportunity of the company in order to receive personal advantage
for himself or others; and (iv) revealing to the company any information or documents
relating to the companys affairs that the office holder has received due to his
position as an office holder. Each person listed in the table under Directors and
Senior Management above is an office holder.

Under
the Companies Law, arrangements regarding the compensation of directors require the
approval of the audit committee, the board of directors and shareholder approval.

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The
Companies Law requires that an office holder of a company promptly disclose any personal
interest that he or she may have and all related material information known to him or her,
in connection with any existing or proposed transaction by the company. In addition, if
the transaction is an extraordinary transaction as defined under the Companies
Law, the office holder must also disclose any personal interest held by the office
holders spouse, siblings, parents, grandparents, descendants, spouses
descendants and the spouses of any of the foregoing. In addition, the office holder must
also disclose any interest held by any corporation in which the office holder owns 5% or
more of the share capital, is a director or general manager or in which he or she has the
right to appoint at least one director or the general manager. An extraordinary
transaction is defined as a transaction other than in the ordinary course of
business, otherwise than on market terms or that is likely to have a material impact on
the companys profitability, assets or liabilities.

Under
the Companies Law, after the office holder complies with the disclosure requirements
described above, only board approval is required for any transaction that is not an
extraordinary transaction, unless the articles of association of the company provide
otherwise, and provided the transaction is not adverse to the companys interest. If
the transaction is an extraordinary transaction, the company must receive any approval
stipulated by its articles of association, the approval of the audit committee, the
approval of the board of directors and shareholder approval. An office holder who has a
personal interest in a matter that is considered at a meeting of the board of directors or
the audit committee may not be present at this meeting or vote on this matter unless the
majority of the board members or members of the audit committee, as applicable, have a
personal interest in such matter and in such case, the matter should also be approved by
the shareholders of the company.

The
Companies Law applies the same disclosure requirements to a controlling shareholder of a
public company, including a shareholder that holds 25% or more of the voting rights in the
company if no other shareholder owns more than 50% of the voting rights in the company.
Extraordinary transactions with a controlling shareholder or in which a controlling
shareholder has a personal interest, and the terms of compensation of a controlling
shareholder or its relative who is an office holder or an employee of the company, require
the approval of the audit committee, the board of directors and the shareholders of the
company. The shareholder approval must include at least one-third of the shareholders who
have no personal interest in the transaction and are voting on the subject matter or,
alternatively, the total shareholdings of those who have no personal interest in the
transaction who vote against the transaction must not represent more than one percent of
the voting rights in the company. In certain cases provided in regulations promulgated
under the Companies Law, shareholder approval is not required.

The
approvals of the board of directors and shareholders are required for a private placement
of securities (or a series of related private placements during a 12-month period or that
are part of one continuous transaction or transactions conditioned upon each other) in
which:

| |  | the
securities issued represent at least 20% of the companys actual voting power prior
to the issuance of such securities, and such issuance increases the relative holdings of
a 5% shareholder or causes any person to become a 5% shareholder, and the consideration
in the transaction (or a portion thereof) is not in cash or in securities listed on a
recognized stock exchange, or is not at a fair market value; or
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| |  | a
person would become, as a result of such transaction, a controlling shareholder of the
company.
| | - | -------------------------------------------------------------------------------------------------

Under
the Companies Law, a shareholder has a duty to act in good faith towards the company and
other shareholders and to refrain from abusing his power in the company including, among
other things, voting in a general meeting of shareholders on the following matters:

| |  | any
amendment to the articles of association;
| | - | ---------------------------------------------

| |  | an
increase of the company's authorized share capital;
| | - | ------------------------------------------------------

| |  | a
merger; or
| | - | ------------

| |  | approval
of interested party transactions that require shareholder approval.
| | - | ----------------------------------------------------------------------------

In
addition, any controlling shareholder, any shareholder who knowingly possesses power to
determine the outcome of a shareholder vote and any shareholder who, pursuant to the
provisions of a companys articles of association, has the power to appoint or
prevent the appointment of an office holder in the company, is under a duty to act with
fairness towards the company. The Companies Law does not describe the substance of this
duty.

For
information concerning personal interests of certain of our office holders and our
principal shareholders in certain transactions with us, see Item 7.B. Related Party
Transactions.

Exculpation, Insurance
and Indemnification of Directors and Officers

Under
the Companies Law, an Israeli company may not exempt an office holder from liability with
respect to a breach of his duty of loyalty, but may exempt in advance an office holder
from his liability to the company, in whole or in part, with respect to a breach of his
duty of care, provided, however, that such a breach is not related to a distribution of a
dividend or any other distribution by the company.

Office
Holders Insurance

Our
articles of association provide that, subject to the provisions of the Companies Law, we
may enter into a contract for insurance of all or a part of the liability of any of our
office holders imposed on the office holder in respect of an act performed in his or her
capacity as an office holder, in respect of each of the following:

| |  | a
breach of his duty of care to us or to another person;
| | - | --------------------------------------------------------

| |  | a
breach of his duty of loyalty to us, provided that the office holder acted in good faith
and had reasonable cause to assume that such act would not prejudice our interests; or
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
financial obligation imposed on him or her in favor of another person.
| | - | ------------------------------------------------------------------------

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Indemnification
of Office Holders

Our
articles of association provide that, subject to the provisions of the Companies Law, we
may indemnify our office holders in respect of an obligation or expense specified below
imposed on an office holder in respect of an act performed in his or her capacity as an
office holder, as follows:

| | (i)       
a
financial obligation imposed on him or her in favor of another person by a
          court judgment, including a compromise judgment or an arbitrators award
          approved by court;
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (ii)       
reasonable
litigation expenses, including attorneys fees, incurred by the           office
holder as a result of an investigation or proceeding instituted against           the
office holder by a competent authority, provided that such investigation or
          proceeding concluded without the filing of an indictment against the office
          holder; and either (a) concluded without the imposition of any financial
          liability in lieu of a criminal proceeding; or (b) a financial liability was
          imposed on him in lieu of a criminal proceeding for an offense that does not
          require proof of criminal intent; and
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (iii)       
reasonable
litigation expenses, including attorneys fees, expended by the           office
holder or charged to the office holder by a court, in a proceeding           instituted
against the office holder by the company or on its behalf or by           another person,
or in a criminal charge from which the office holder was           acquitted, or in a
criminal proceeding in which the office holder was convicted           of an offense that
does not require proof of criminal intent.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We
may undertake to indemnify an office holder as aforesaid, (a) prospectively, provided that
in respect of (i) above, the undertaking is limited to categories of events that in the
opinion of our board of directors are foreseeable in light of the companys
operations at the time that the undertaking to indemnify is given, and for an amount or
criteria that our board has determined as reasonable under the circumstances, and further
provided that that such events and amount or criteria are indicated in the indemnification
undertaking; and (b) retroactively.

We
have entered into an undertaking to indemnify our office holders in specified limited
categories of events and in specified amounts, subject to the limitations set by the
Companies Law and our articles of association, as described above. For more information,
see Item 7.B. Related Party Transactions  Indemnification of Office
Holders.

Limitations
on Exemption, Insurance and Indemnification

The
Companies Law provides that a company may not indemnify an office holder, enter into an
insurance contract that would provide coverage for any monetary liability, or exempt an
office holder from liability, with respect to any of the following:

| |  | a
breach by the office holder of his duty of loyalty, except that the company may indemnify
or provide insurance coverage to the office holder if the office holder acted in good
faith and had a reasonable basis to believe that the act would not prejudice the company;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
breach by the office holder of his duty of care if the breach was done intentionally or
recklessly, except for a breach that was made in negligence;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | any
act or omission done with the intent to derive an illegal personal benefit; or
| | - | ----------------------------------------------------------------------------------

64

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| |  | any
fine levied against the office holder.
| | - | ------------------------------------------

In
addition, under the Companies Law, indemnification of, and procurement of insurance
coverage for, our office holders must be approved by our audit committee and our board of
directors and, in specified circumstances, by our shareholders.

We
have procured directors and officers liability insurance and obtained all
necessary approvals.

|D. | Employees
|-- | ---------

The
table below presents certain information regarding the number of our employees, the sector
in which they are employed and their geographical area of employment, in the periods
indicated.

| |                                   | 2006 | 2005 | 2004
| | --------------------------------- | ---- | ---- | ----
|
|
|
|
| | Technical Experts                 |      |      |     
| | Research and Development          |      |      |     
| | Sales, General and Administrative |      |      |     
| |                                   |      |      |     
| | Total                             |      |      |     
| |                                   |      |      |     
| |                                   |      |     
| | In Israel                         |      |      |     
| | In Europe                         |      |      |     
| | In the United States              |      |      |     

The
numbers of employees indicated in the table above include expert consultants who we train
for the implementation of our modernization tools and methodologies.

With
respect to our employees in Israel, we are subject to various Israeli labor laws and labor
practices, and to administrative orders extending certain provisions of collective
bargaining agreements between the Histadrut (Israels General Federation of Labor)
and the Coordinating Bureau of Economic Organizations (the Israeli federation of
employers organizations) to all private sector employees. For example, mandatory
cost of living adjustments, which compensate Israeli employees for a portion of the
increase in the Israeli consumer price index, are determined on a nationwide basis.
Israeli law also requires the payment of severance benefits upon the termination,
retirement or death of an employee. We meet this requirement by contributing on an ongoing
basis towards managers insurance funds that combine pension, insurance
and, if applicable, severance-pay benefits. In addition, Israeli employers and employees
are required to pay specified percentages of wages to the National Insurance Institute,
which is compatible with the United States Social Security Administration. Other
provisions of Israeli law and regulations govern matters such as the length of the
workday, minimum wages, other terms of employment and restrictions on discrimination. We
are also subject to the labor laws and regulations of other jurisdictions in the world
where we have employees.

65

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|E. | Share
Ownership
|-- | ---------------

The
following presents information regarding the ownership of our ordinary shares by the
persons listed in the table under Directors and Senior Management, as of March
22, 2007. The percentage of outstanding ordinary shares is based on 15,374,124 ordinary
shares outstanding as of March 22, 2007 (excluding 1,647,594 shares held by two of our
wholly owned subsidiaries).

Unless
otherwise specifically indicated, the address of each of the persons set forth below is at
c/o BluePhoenix, 8 Maskit Street, Herzlia 46120.

|Name                          | Shares beneficially owned(1) | Options to purchaseordinary shares
|----------------------------- | ---------------------------- | ----------------------------------
|
|
|
|
|Arie Kilman (2)               |                              |                                   
|Gad Goldstein                 |                              |                                   
|Aaron Crystal                 |                              |                                   
|Shai Beilis                   |                              |                                   
|Iris Yahal                    |                              |                                   
|Naamit Salomon                |                              |                                   
|Gur Shomron                   |                              |                                   
|Guy Bernstein                 |                              |                                   
|Michael Chill                 |                              |                                   
|Amira Berkovitz-Amir          |                              |                                   
|All directors and officers as |                              |                                   
|a group (10 persons) (3) (5)  |                              |                                   

| | 
| | 

| | (1) | Each
of the directors and executive officers whose holdings are not separately
               specified in the above table beneficially owns less than one percent of
our                outstanding ordinary shares. Options to purchase ordinary shares that
are                currently exercisable or exercisable within 60 days after the date of
this                report are deemed outstanding and beneficially owned by the person
holding the                options for the purpose of computing the percentage ownership
of that person,                but are not treated as outstanding for the purpose of
computing the percentage                ownership of any other person.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | Mr.
Kilman was granted options to purchase ordinary shares under the following
               terms: (i) currently exercisable options to purchase 375,000 ordinary
shares at                $2.25 per share, which expire in April 2013; (ii) currently
exercisable options                to purchase 200,000 ordinary shares exercisable at
$4.00 per share, currently                exercisable which expire in September 2013; and
(iii) currently exercisable                options to purchase 150,000 ordinary shares at
$6.00 per share, which expire in                September 2015.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (3) | Includes
294 shares that Anat Crystal, Mr. Crystals spouse, beneficially
               owns.
| | --- | ----------------------------------------------------------------------------------------------

| | (4) | Mrs.
Yahal was granted options to purchase ordinary shares under the following
               terms: (i) currently exercisable options to purchase 10,000 ordinary
shares                exercisable at $5.50 per share, which expire in October 2010; and
(ii) currently                exercisable options to purchase 35,000 ordinary shares at
$5.00 per share, which                expire in December 2015.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (5) | Includes
currently exercisable options to purchase 770,000 ordinary shares, held                by
two of our directors who are also officers.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------

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Arrangements Involving
the Issuance of BluePhoenixs Shares or Grant of Options to Purchase Shares

In
1996, we adopted two option plans. One of these option plans has been terminated after all
options granted under it had been exercised. Pursuant to our other 1996 option
plan, as amended, we reserved 3,700,000 ordinary shares for issuance to our and our
subsidiaries directors, officers, consultants and employees. As of March 22, 2007,
options to purchase 2,145,017 ordinary shares were outstanding under the plan. The
exercise price of the options granted under the 1996 option plan ranges from $2.25 to
$10.50.

Our
board of directors administers our 1996 option plan. Under the 1996 option plan, as
amended, options to purchase our ordinary shares may be granted to our and our
subsidiaries directors, officers, consultants and employees. Our board of directors
is empowered, among other things, to designate the grantees, dates of grant, the exercise
price of the options and the terms of exercise of the options. Unless determined otherwise
by the board, the options generally vest over a three-year period. Unvested options are
forfeited shortly following termination of employment, unless otherwise agreed. Under the
1996 option plan, the grantee is responsible for all personal tax consequences of the
grant and the exercise of the options. Each option granted under the 1996 option plan is
exercisable during a term of ten years from the date of grant of the option. The 1996
option plan will expire on August 6, 2013, except as to options outstanding on that date.

In
anticipation of the effect of the adoption of Statement of Accounting Standard No. 123R,
or SFAS 123R, and under the management belief that in the currently increasing competition
in the labor market, an acceleration may have a positive effect on employee morale and
retention, our board of directors and compensation committee approved as of December 27,
2005, the acceleration of several outstanding unvested options under our 1996 option plan
so as to be fully-vested as of such date (see Notes 1J and 11B1 to our financial
statements). As a result, options to purchase 144,900 BluePhoenix ordinary shares and
options to purchase 1,228,997 shares of Mainsoft, were accelerated. The acceleration of
options held by our officers who also serve as directors of the company, was also approved
by the companys shareholders as required under the law.

67

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# ITEM 7. MAJOR
SHAREHOLDERS AND RELATED PARTY TRANSACTIONS

|A. | Major
Shareholders
|-- | ------------------

The
following table presents information regarding the ownership of our ordinary shares at
March 22, 2007 by each person known to us to be the beneficial owner of 5% or more of our
ordinary shares. Options to purchase ordinary shares that are currently exercisable or
exercisable within 60 days after the date of this report are deemed outstanding and
beneficially owned by the person holding the options for the purpose of computing the
percentage ownership of that person, but are not treated as outstanding for the purpose of
computing the percentage ownership of any other person. Except where we indicated
otherwise, we believe, based on information furnished by these owners, that the beneficial
owners of our shares listed below have sole investment and voting power with respect to
the shares.

| | Name and Address            | Number | Percent (1)
| | --------------------------- | ------ | -----------
|
|
|
|
| | Formula Systems (1985) Ltd. |        |            
| | Aaron Crystal               |        |            
| | Arie Kilman                 |        |            

| | 
| | 

| | (1) | Unless
otherwise indicated, percentages in the above table are based on           15,374,124
ordinary shares outstanding as of March 22, 2007, and do not include           1,647,594
ordinary shares that two of our subsidiaries hold. Pursuant to Israeli           law,
these shares do not confer upon our subsidiaries any voting rights           (although
such shares entitle their holders to participation rights upon           distribution).
In January 2006, we sold 136,000 shares held by one of our           subsidiaries to
Israeli institutional investors in Israel. In February 2006, we           sold 86,971
shares held by one of our subsidiaries to Outlook Systems Ltd. For           more
information about the sale of our shares to Outlook Systems, see Item
          4.B. Business Overview  Investments and Acquisitions  Outlook.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | Emblaze
Ltd. owns 42.4% of the outstanding share capital of Formula. Messrs.           Naftali
Shani and Eli Reifman, directors of Emblaze Ltd., hold 13.8% and 9.4% of           the
outstanding share capital of Emblaze Ltd., respectively. Our chairman of the
          board, Gad Goldstein, is a president and chief executive officer of Formula and
          owns 2.5% of the outstanding shares of Formula.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (3) | Includes
294 shares that Anat Crystal, Mr. Crystals spouse, beneficially           owns.
During 2004 through March 22, 2007, Mr. Crystal sold 337,038 ordinary           shares in
the open market.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (4) | Includes
currently exercisable options to purchase 725,000 ordinary shares. The
          percentage of holdings includes those options.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------

| | (5) | Percentage
is calculated based on 16,144,124 ordinary shares outstanding, which           include
currently exercisable options to purchase 770,000 ordinary shares held           by Mr.
Kilman.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

All
of our ordinary shares have equal voting rights. Under our two buy-back programs (as
described in Item 5.B. Liquidity and Capital Resources above), two of our
subsidiaries purchased 1,870,565 of our ordinary shares, of which 136,000 shares were sold
in January 2006 to Israeli institutional investors in Israel and 86,971 shares were sold
in February 2006 to Outlook Systems Ltd. Under applicable Israeli law, so long as the
shares are held by our subsidiaries, they have no voting rights but such shares confer
upon their holders participation rights upon distribution.

68

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As
of March 8, 2007, there were 31 record holders of our ordinary shares. Of
these record holders, 16 holders had mailing addresses in the United States owning an
aggregate less than 1% of our outstanding ordinary shares, excluding the shares that our
subsidiaries hold. As of December 6, 2006 we had
approximately 1,558 beneficial shareholders.

|B. | Related
Party Transactions
|-- | --------------------------

Management
Agreement with Formula

On
January 1, 1996, we signed a letter agreement with Argotec Ltd., at that time our
parent company wholly owned by Formula, pursuant to which Formula provides us with
administrative and management support. Under the agreement, Formula provides three of our
directors, including our chairman of the board, who is active in the direction of our
business. Additionally, Formula arranges to have certain volume discounts extended to us
as part of Formulas control group, and Formula provides us with administrative
services, including services relating to insurance, human resources, global planning, real
property leasing, and the department of motor vehicles.

Pursuant
to the letter agreement, we pay Formula in return for its services, a management fee equal
to 3.0% of our revenues, up to a maximum of $180,000 per year. The amount of management
fee was negotiated between us and Argotec in 1996 when we initially entered into the
letter agreement. The amount of the fee was determined primarily on the parties good
faith estimates of the value of services to be provided by the three directors seconded to
us by Formula and the extent of our expected cost savings to be generated by
Formulas assistance in obtaining volume discounts and the provision of
administrative support. Although we did not engage in actual negotiations with potential
third-party providers of comparable services, the fee was based in part on our market
knowledge of the cost of obtaining such services from third parties and/or developing the
internal resources necessary to carry out these functions ourselves.

We
pay the management fee to Formula in installments at the end of each quarter. For the year
ended December 31, 2006, a management fee of $180,000 was payable to Formula under this
agreement, representing 0.3% of our revenues in 2006. In addition, we reimburse Formula
from time to time for expenses Formula incurred on our behalf.

For
more information regarding the positions that some of our directors hold in Formula and
their holdings in Formulas shares, see Item 6.A. Directors and Senior
Management and Item 7.A. Major Shareholders.

Cooperation
with Matrix

We
have been cooperating with Matrix IT Ltd., a subsidiary of Formula, in performance of
modernization projects in Israel and license agreements since 1996. In 2006, we renewed
the legal terms of our cooperation with Matrix by signing a cooperation agreement. In
2006, revenues from sales through Matrix amounted to $1.2 million.

Matrix
also serves as a subcontractor in several projects we perform. In 2006, the aggregate
amount paid by us to Matrix subcontractors was $1.2 million.

69

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Registration
Rights Agreements

In
1997, we entered into a registration rights agreement with Formula, Dan Goldstein,
Aaron Crystal and two additional shareholders, referred to collectively as the holders.
Under this registration rights agreement, the holders have certain registration rights
with respect to their ordinary shares. We agreed that, beginning January 31, 1998, at the
request of the holders of a majority of the shares held by the persons and entities who
signed the agreement, and on no more than two occasions, we will file a registration
statement under the Securities Act for an offering of their shares with respect to which
registration is requested. In addition, if we otherwise propose to register our ordinary
shares under the Securities Act, these holders may request that we register their shares
as well, subject to certain limitations. We shall bear all fees and expenses in connection
with the registration, except that the holders will pay all fees and expenses of their own
counsel and all underwriting discounts and commissions relating to their shares. As of
March 22, 2007, the holders did not exercise their rights pursuant to the agreement.

In
October 2002, we granted certain registration rights to Formula, Mr. Arie Kilman and
another shareholder of Liraz in the Share Exchange Agreement with those shareholders.
Under this agreement, if we propose to register our ordinary shares under the Securities
Act, each of these holders may request that we register their shares as well, subject to
certain limitations. We shall bear all expenses in connection with the registration,
provided that all underwriting commissions shall be paid by the holders selling shares
with respect to their shares sold.

In
May 2004, our board of directors approved to include 400,000 BluePhoenixs shares
held by certain directors and officers in a registration statement filed by us on June 1,
2004 and declared effective on March 15, 2005.

In
December 2006, we granted CodeStream certain registration rights with respect to shares
underlying convertible debentures to be issued to CodeStream or its successors. Under this
agreement, subject to certain conditions, we agreed that, at the request of the holders of
a majority of the shares underlying each of the debentures, given within 10 business days
after issuance of the debenture, we will file a registration statement under the
Securities Act for an offering of the shares underlying the debenture. In addition, if we
otherwise propose to register our ordinary shares under the Securities Act, the holders of
the debentures may request that we register their shares as well, subject to certain
limitations. In the event that holders of 50% or more of the principal amount of a
debenture request repayment of the debenture prior to its due date, we will be released
from the obligations described above. For more information about the transaction with
CodeStream, see Item 4.B. Business OverviewInvestments and
AcquisitionsCodeStream.

Transactions
Between Us and Our Subsidiaries

We
currently hold 40% of the outstanding share capital of MultiConn Technologies and have an
option to increase our holdings in MultiConn Technologies to 60%. As of March 22, 2007, we
lent to MultiConn Technologies an aggregate amount of $2.5 million. For more information
about M.S.I. MultiConn and MultiConn Technologies, see Item 4.B. Business
OverviewInvestments and AcquisitionsMultiConn.

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In
2000, we entered into a management agreement with Mainsoft, under which we provide
Mainsoft with management and advisory consulting services. Until the end of 2005, Mainsoft
paid us in exchange for our services aggregate consideration of $120,000 per year.
Beginning with 2006, the management fees were reduced to $60,000 per year.

In
February 2005, we entered into an alliance agreement with Zulu for cooperation in
marketing and selling Zulus and our software tools and services. For more
information about Zulu, see Item 4.B. Business OverviewInvestments and
AcquisitionsZulu.

Transactions
between Us and Our Chief Executive Officer

Mr.
          Kilman, in his former position as Lirazs chairman of the board of
          directors, was granted by Liraz, in May 2002, a loan in an amount equal to
          approximately $300,000. As of March 22, 2006, Mr. Kilman repaid the entire
          amount of the loan, including principal, linkage differentials and accrued
          interest. For more information relating to the loan granted to Mr. Kilman, see
          Item 6.B. Compensation.

Services
Agreement with TIS

In
January 2006, we entered into a services agreement with TIS Ltd., or TIS, a Cypriot
company. Under the agreement, TIS provides us with consulting and other professional
services. When we signed the agreement with TIS, 38.8% of the share capital of TIS was
held by CTI Ltd., or CTI, a Cypriot company. Mr. Kilman, our chief executive officer and
director, held a 49% interest in CTI. Therefore, the transaction was considered as a
related party transaction and we obtained the necessary approvals required under Israeli
law. In November 2006, Mr. Kilman notified us that CTI sold the shares it held in TIS and
it was no longer a shareholder of TIS. In 2006, fees paid to TIS amounted to $300,000.

Indemnification
of Office Holders

Since
July 2003, we grant to our office holders indemnification letters covering acts
performed in their capacity as office holders or employees of our company. On December 27,
2005, our shareholders approved an amendment to those indemnification letters, following a
recent amendment to the Companies Law. Pursuant to the amended indemnification letters, we
undertake to indemnify each office holder to the maximum extent permitted by law in
respect of the following for any act or omission taken or made by the office holder in his
or her capacity as an office holder of our company:

| |  | any
financial obligation imposed on the office holder in favor of another person by a court
judgment, including a settlement or an arbitrators award approved by court,
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | all
reasonable litigation expenses, including attorneys fees, expended by the office
holder as a result of an investigation or proceeding instituted against the office holder
by a competent authority, provided that such investigation or proceeding concluded
without the filing of an indictment against the office holder and either (a) concluded
without the imposition of any financial liability in lieu of criminal proceedings; or (b)
concluded with the imposition of a financial liability in lieu of criminal proceeding but
relates to a criminal offense that does not require proof of mens rea(criminal
intent); and
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

71

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| |  | all
reasonable litigation expenses, including attorneys fees, expended by the office
holder or charged to him or her by a court in a proceeding instituted against the office
holder by us or on our behalf or by another person, or in any criminal proceedings in
which the office holder is acquitted, or in any criminal proceedings of a crime that does
not require proof of mens rea (criminal intent) in which the office holder is
convicted.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The
indemnification also applies to any action taken by the office holder in respect of an act
performed in his or her capacity as an office holder or an employee of one of our
subsidiaries or as a director or observer at board of directors meetings of one of
our affiliates. Our undertaking for indemnification is limited to up to 25% of our
shareholders equity at the time of the claim for indemnification.

Our
undertaking for indemnification does not apply to a liability incurred as a result of any
of the following:

| |  | a
breach by the office holder of his or her duty of loyalty, unless, to the extent
permitted by law, the office holder acted in good faith and had reasonable cause to
assume that such act would not prejudice the interests of our company;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
willful breach by the office holder of his or her duty of care, unless such breach was
solely due to               negligence;
| | - | --------------------------------------------------------------------------------------------------------------------------------

| |  | an
action taken or not taken with the intent of unlawfully realizing personal gain;
| | - | -----------------------------------------------------------------------------------

| |  | a
fine or penalty imposed on the office holder for an offense; and
| | - | ------------------------------------------------------------------

| |  | a
counterclaim made by us in connection with a claim against us filed by the office holder.
| | - | -------------------------------------------------------------------------------------------

Our
undertaking for indemnification is limited to such events specified in the indemnification
letter and determined by our board of directors to be foreseeable in light of the
companys operations.

Under
the indemnification letters, we exempt our office holders to the fullest extent permitted
by law, from liability for damages caused as a result of a breach by the office holder of
his or her duty of care to the company.

Office
Holders Insurance

We
procured an insurance policy covering our directors and officers liability.
Our subsidiaries participate in the premium payments of the insurance, on a proportional
basis. The total premium we paid during 2006 was approximately $50,000.

72

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|C. | Interests
of Expert and Counsel
|-- | -------------------------------

Not applicable.

# ITEM 8. FINANCIAL
INFORMATION

|A. | Consolidated
Statements and Other Financial Information
|-- | -------------------------------------------------------

Financial Statements

The
financial statements required by this item are found at the end of this annual report,
beginning on page F-1.

Legal Proceedings

We
are not involved in any proceedings in which any of our directors, members of our senior
management or any of our affiliates is either a party adverse to us or to our subsidiaries
or has a material interest adverse to us or to our subsidiaries. We are also not involved
in any material legal proceedings, except as described below.

In
July 2003, a former Liraz shareholder filed an application with the Tel Aviv, Jaffa
District Court to approve a claim filed by him against us, as a class action. The claim
relates to the acquisition of Liraz shares, which we completed in March 2003. The
shareholder alleges that the share price we paid to Lirazs shareholders in the
tender offer and in a subsequent mandatory purchase was lower than the fair price of Liraz
shares. The maximum amount of the claim is approximately $7.3 million in the aggregate.
Under Israeli law, the courts approval is required for the plaintiff to represent
all of the shareholders of Liraz who sold their shareholdings to us pursuant to the tender
offer and the mandatory acquisition. The plaintiff has applied for such approval in the
lawsuit. Based on our analysis of the statement of claim, including an evaluation of the
fair value of the Liraz shares, and the price paid for Liraz in a previous transaction
immediately prior to the tender offer, we believe that the allegations against us in this
proceeding are without merit and we intend to vigorously defend the claim and contest the
allegations made therein.

Dividend policy

We
have never declared or paid dividends to our shareholders and we do not intend to pay
dividends in the future. We anticipate that we will retain all of our future earnings for
use in the expansion and operation of our business. We are not subject to any contractual
restrictions on paying dividends. Any future determination relating to our dividend policy
will be made at the discretion of our board of directors and will depend on a number of
factors, including our future earnings, capital requirements, financial condition, future
prospects and other factors as the board of directors may deem relevant. Israeli law
limits the distribution of cash dividends to the greater of retained earnings or earnings
generated over the two most recent years, in either case provided that we reasonably
believe that the dividend will not render us unable to meet our current or foreseeable
obligations when due.

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|B. | Significant
Changes
|-- | -------------------

Except
as otherwise disclosed in this annual report, there has been no material change in our
financial position since December 31, 2006.

# ITEM 9. THE OFFER AND
LISTING

|A. | Offer
and Listing Details
|-- | -------------------------

The
following table shows the high and low closing price for our ordinary shares on the NASDAQ
Global Market for the periods indicated.

|Calendar Period          | Price Per Share
|------------------------ | ---------------
|
|
|
|
|2002                     |                
|2003                     |                
|2004                     |                
|2005                     |                
|2006                     |                
|First Quarter            |                
|Second Quarter           |                
|Third Quarter            |                
|Fourth Quarter           |                
|September                |                
|October                  |                
|November                 |                
|December                 |                
|2007                     |                
|January                  |                
|February                 |                
|March (through March 22) |                

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The
following table shows the high and low closing price for our ordinary shares on the TASE
for the periods indicated.

|Calendar Period          | Price Per Share
|------------------------ | ---------------
|
|
|
|
|2002                     |                
|2003                     |                
|2004                     |                
|2005                     |                
|First Quarter            |                
|Second Quarter           |                
|Third Quarter            |                
|Fourth quarter           |                
|2006                     |                
|First Quarter            |                
|Second Quarter           |                
|Third Quarter            |                
|Fourth quarter           |                
|September                |                
|October                  |                
|November                 |                
|December                 |                
|2007                     |                
|January                  |                
|February                 |                
|March (through March 22) |                

The
following table shows the high and low closing price for our series A convertible notes on
the TASE for the periods indicated.

|Calendar Period                  | Price Per note
|-------------------------------- | --------------
|
|
|
|
|2006 (from February 12)          |               
|First quarter (from February 12) |               
|Second quarter                   |               
|Third quarter                    |               
|Fourth quarter                   |               
|September                        |               
|October                          |               
|November                         |               
|December                         |               
|2007                             |               
|January                          |               
|February                         |               
|March (through March 22)         |               

|B. | Plan
of Distribution
|-- | --------------------

Not applicable.

|C. | Markets
|-- | -------

Our
ordinary shares have been traded in the United States on the NASDAQ Global Market since
our initial public offering on January 30, 1997 and were not publicly traded prior to
this date. The symbol on the NASDAQ Global Market for our ordinary shares is BPHX. On
January 21, 2001, we listed our ordinary shares for trading on the TASE.

75

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Our
series A convertible notes have been traded on the TASE since February 12, 2006.

Pursuant
to Marketplace Rule 4350(a) of NASDAQ, we received a permanent exemption from Marketplace
Rule 4350(b)(1)(A), which requires a company to distribute to its shareholders copies of
its annual report containing its audited financial statements. We follow the common
practice among TASE companies, and do not send our annual financial statements to
shareholders. A copy of our annual report on Form 20-F is posted on our website promptly
after it is filed with the SEC and the TASE.

|D. | Selling
Shareholders
|-- | --------------------

Not applicable.

|E. | Dilution
|-- | --------

Not applicable.

|F. | Expenses
of the Issue
|-- | ---------------------

Not applicable.

# ITEM 10. ADDITIONAL
INFORMATION

|A. | Share
Capital
|-- | -------------

Not applicable.

|B. | Memorandum
and Articles of Association
|-- | --------------------------------------

We
are registered with the Israeli Companies Register under the number 52-004306-8. Our
objects are specified in our memorandum of association. These objects include:

| |  | operating
within the field of informational and computer systems;
| | - | -----------------------------------------------------------------

| |  | providing
management, consulting and sale services for computers, computer equipment, software for
         computers and for information systems;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
business of systems analysis, systems programming and computer programming; and
| | - | -----------------------------------------------------------------------------------

| |  | establishing
facilities for instruction and training for computers and digital systems.
| | - | ---------------------------------------------------------------------------------------

Description of Our Share
Capital

Our
company share capital consists of ordinary shares. Our articles of association do not
restrict in any way the ownership of our ordinary shares by nonresidents, except that
these restrictions may exist with respect to citizens of countries that are in a state of
war with Israel.

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Transfer of Shares

Fully
paid ordinary shares are issued in registered form and may be freely transferred under our
articles of association unless the transfer is restricted or prohibited by another
instrument.

Modification of Class
Rights

Under
our articles of association, the rights attached to any class unless otherwise provided by
the terms of the class, including voting, rights to dividends and the like, may be varied
by adoption of the necessary amendment to the articles of association, provided that the
affected shareholders approve the change by a class meeting in which a simple majority of
the voting power of the class represented at the meeting and voting on the matter approves
the change.

Dividend Rights and
Liquidation Rights

We
may declare a dividend to be paid to the holders of ordinary shares according to their
rights and interests in our profits. We may pay the dividend as an allotment of shares or
a distribution of assets. If we do decide to issue dividends by an allotment of shares at
a price lower than the nominal value of those shares, we must convert a portion of our
profits or any other source of equity to share capital in an amount equal to the
difference between the nominal value of the shares and the price paid in the dividend. If
dividends remain unclaimed for seven years from the date we declared the dividend, they
lapse and revert back to us. In case of liquidation, after satisfying liabilities to
creditors, our assets will be distributed to the holders of ordinary shares in proportion
to their holdings. This right may be affected by the grant of a preferential dividend or
distribution rights to the holders of a class of shares with preferential rights that may
be authorized in the future.

Redemption provisions

In
accordance with our articles of association, we may issue redeemable shares and
accordingly redeem those shares. Our board may attach to redeemable shares the attributes
of shares, including voting rights and the right to participate in profits.

Voting, Shareholder
Meetings and Resolutions

Holders
of our ordinary shares have one vote for each ordinary share held on all matters submitted
to the vote of shareholders. These voting rights may be affected by the grant of any
special voting rights to the holders of a class of shares with preferential rights that
may be authorized in the future.

We
must hold an annual general meeting once a year with a maximum period of fifteen months
between the meetings. All other meetings of shareholders other than annual general
meetings are considered special general meetings. Our board of directors may, whenever it
decides it is appropriate, and shall, within 21 days after receiving a written demand from
one director or from one or more shareholders representing at least 10% of the outstanding
share capital and 1% of the voting power, call a special general meeting. The quorum
required for a general meeting of shareholders consists of two or more holders present in
person or by proxy who hold or represent at least 35% of the voting power. A meeting
adjourned for a lack of a quorum generally is adjourned to the same day in the following
week at the same time and place or to another later time if such time is specified in the
original notice convening the general meeting or if we give notice to the shareholders of
another time at least 72 hours before the date fixed for the adjourned meeting. At the
reconvened meeting, if a quorum is not present within half an hour from the time appointed
for holding the meeting, the required quorum will consist of two shareholders present in
person or by proxy.

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Under
the Companies Law, unless otherwise provided in the articles of association or applicable
law, all resolutions of the shareholders require a simple majority, except in certain
circumstances provided for under the Companies Law, which require a majority of at least
75% of the shares present at the meeting. In accordance with the Companies Law, all
shareholders meetings require prior notice of at least 21 days. In some instances
specified in regulations promulgated under the Companies Law, a 35-day prior notice should
be given of a shareholders meeting.

Under
the Companies Law, a shareholder has a duty to act in good faith towards the company in
which he holds shares and towards other shareholders and to refrain from abusing his power
in the company including voting in the general meeting of shareholders on:

| |  | any
amendment to the articles of association;
| | - | ---------------------------------------------

| |  | an
increase of the company's authorized share capital;
| | - | ------------------------------------------------------

| |  | a
merger; or
| | - | ------------

| |  | approval
of some of the acts and transactions that require shareholder approval.
| | - | --------------------------------------------------------------------------------

A
shareholder has the general duty to refrain from depriving rights of other shareholders.
Any controlling shareholder, any shareholder who knows that it possesses the power to
determine the outcome of a shareholder vote and any shareholder that, under the provisions
of the articles of association, has the power to appoint an office holder in the company,
is under a duty to act in fairness towards the company. The Companies Law does not
describe the substance of this duty.

Election of Directors

Our
ordinary shares do not have cumulative voting rights in the election of directors. As a
result, the holders of ordinary shares that represent more than 50% of the voting power
represented at a shareholders meeting have the power to elect all of our directors, other
than the outside directors that are appointed by a special majority of shareholders. For a
summary of those provisions in our articles of association with respect to the directors,
see Item 6. Directors, Senior Management, and Employees.

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Anti-Takeover Provisions;
Mergers and Acquisitions under Israeli Law

Mergers

The
Companies Law includes provisions that allow a merger transaction and requires that each
company that is party to a merger approve the transaction by its board of directors and a
vote of the majority of its shares voting on the proposed merger at a shareholders
meeting called on at least 21 days prior notice. In determining whether a majority
has approved the merger, shares held by the other party to the merger or any person
holding at least 25% of the other party to the merger are excluded from the vote. The
Companies Law does not require court approval of a merger other than in specified
situations. Upon the request of a creditor of either party to the proposed merger, the
court may delay or prevent the merger if it concludes that there exists a reasonable
concern that as a result of the merger, the surviving company will be unable to satisfy
the obligations of any of the parties to the merger. In addition, a merger may not be
completed unless at least 70 days have passed from the time that a proposal for approval
of the merger has been filed with the Israeli registrar of companies.

Tender
Offers

The
Companies Law also provides that an acquisition of shares of a public company on the open
market must be made by means of a tender offer if as a result of the acquisition the
purchaser would become a 25% shareholder of the company. The rule does not apply if there
is already another 25% shareholder of the company. Similarly, the Companies Law provides
that an acquisition of shares in a public company must be made by means of a tender offer
if, as a result of the acquisition, the purchaser would become a 45% shareholder, unless
there is a 50% shareholder of the company. These rules do not apply if the acquisition is
made by way of a merger as opposed to a tender offer. Regulations adopted under the
Companies Law provide that these tender offer requirements do not apply to companies whose
shares are listed for trading outside of Israel if, according to the law in the country in
which the shares are traded, including the rules and regulations of the stock exchange on
which the shares are traded, there is either a limitation on acquisition of any level of
control of the company, or the acquisition of any level of control requires the purchaser
to do so by means of a tender offer to the public. The Companies Law also provides that if
following any acquisition of shares, the acquirer holds 90% or more of the companys
shares or of a class of shares, the acquisition must be made by means of a tender offer
for all the target companys shares or all the shares of the class, as applicable. An
acquirer who wishes to eliminate all minority shareholders must do so by way of a tender
offer and acquire 95% of all shares not held by or for the benefit of the acquirer before
the acquisition. If, however, the tender offer to acquire 95% is not successful, the
acquirer may not acquire shares tendered if by doing so the acquirer would own more than
90% of the shares of the target company.

|C. | Material
Contracts
|-- | ------------------

We
consider the agreements related to the $5 million private placements of convertible
debentures and warrants completed in March 2004, the issuance of the series A convertible
notes in an aggregate principal amount of NIS 54.0 million (that were equal at the time of
issuance to approximately $11.5 million) and the purchase agreement with CodeStream, as
material contracts. For a summary of the terms of these transactions, see Item 4.B.
Business Overview  Investments and Acquisitions and Item 5.B. Liquidity
and Capital Resources. In addition, the agreement with SDC Udvikling described below
is material to our business.

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Services
Agreement with SDC Udvikling

In
October 2002, we entered into a services agreement with an affiliated company of SDC,
named SDC Udvikling A/S, for the provision of IT development services related to our tool,
AppBuilder. Under the agreement, SDC Udvikling has been purchasing from us various
services pursuant to specific amendments to the agreement and purchase orders signed from
time to time. SDC Udvikling accounted for 11% and 17% of our revenues in 2006 and 2005.

|D. | Exchange
Controls
|-- | -----------------

Under
current Israeli regulations, we may pay dividends or other distributions in respect of our
ordinary shares either in non-Israeli or Israeli currencies. If we make these payments in
Israeli currency, they will be freely transferred in non-Israeli currencies at the rate of
exchange prevailing at the time of conversion. Because exchange rates between the NIS and
the dollar fluctuate continuously, a U.S. shareholder will be subject to the risk of
currency fluctuations between the date when we declare NIS-denominated dividends and the
date when we pay them in NIS. See Item 3.D. Risk Factors.

Nonresidents
of Israel may freely hold and trade our securities pursuant to the general permit issued
under the Israeli Currency Control Law, 1978. Neither our memorandum of association nor
the laws of the State of Israel restrict in any way the ownership of our ordinary shares
by nonresidents, except that these restrictions may exist with respect to citizens of
countries that are in a state of war with Israel.

|E. | Taxation
|-- | --------

Israeli Taxation

The
following is a description of material tax consequences regarding the ownership and
disposition of the Companys ordinary shares under Israeli tax laws to which U.S. and
other non-Israeli shareholders may be subject. The information below does not apply to
specified persons or cover specified situations. Therefore, you are advised to consult
your own tax advisor as to particular tax consequences unique to you related to an
investment in our ordinary shares including the effects of applicable Israeli or foreign
or other tax laws and possible changes in the tax laws.

To
the extent that the discussion is based on legislation yet to be judicially or
administratively interpreted, we cannot assure you that the views we express herein will
accord with any such interpretation in the future.

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Tax
Consequences Regarding Disposition of Our Ordinary Shares

In
general, Israel imposes capital gains tax on the sale of capital assets, including shares
of Israeli companies by both Israeli residents and non-Israeli resident shareholders,
unless a specific exemption is available or unless a tax treaty between Israel and the
shareholders country of residence provide otherwise. Shareholders that are not
Israeli residents are generally exempt from Israeli capital gains tax on any gain derived
from the sale of our ordinary shares, provided that (i) such shareholders did not
acquire the shares prior to our initial public offering; and (ii) such gains did not
derive from a permanent establishment of such shareholders in Israel. However, non-Israeli
corporations will not be entitled to the foregoing exemption if an Israeli resident
(a) has a controlling interest of 25% or more in such non-Israeli corporation; or
(b) is the beneficiary of or is entitled to 25% or more of the revenues or profits of
such non-Israeli corporation, whether directly or indirectly.

In
certain instances where our non-Israeli shareholders may be liable to Israeli tax on the
sale of our ordinary shares, the payment of the consideration may be subject to Israeli
withholding tax.

In
addition, in the case when the sale, exchange or disposition of our ordinary shares by
shareholders who are U.S. residents (within the meaning of the U.S.-Israel Tax
Treaty) holding the ordinary shares as a capital asset will be also exempt from Israeli
capital gains tax under the U.S.-Israel Tax Treaty, unless, either (i) the
shareholders hold, directly or indirectly, shares representing 10% or more of our voting
shares during any part of the 12-month period preceding such sale, exchange or
disposition; or (ii) the capital gains arising from such sale, exchange or
disposition are attributable to a permanent establishment of the shareholders located in
Israel. In such case, the shareholders would be subject to Israeli capital gain tax, to
the extent applicable, as mentioned above. However, under the U.S.-Israel Tax Treaty, the
U.S. resident would be permitted to claim a credit for such taxes against the
U.S. federal income tax imposed on the sale, exchange or disposition, subject to the
limitation in the U.S. law applicable to foreign tax credits. The U.S.-Israel Tax
Treaty does not relate to U.S. state or local taxes.

Taxes
Applicable to Dividends

Nonresidents
of Israel are generally subject to Israeli income tax on the receipt of dividends paid on
our ordinary shares at the rate of 20% or 15% for dividends or income generated by an
approved enterprise, which tax will be withheld at source, unless a different rate is
provided in a treaty between Israel and the shareholders country of residence.

However,
the tax rate on dividends paid to a substantial shareholder (which is someone
who alone, or together with another person, holds, directly or indirectly, at least 10% in
one or all of any of the means of control in the corporation) is 25%.

Under
Israeli tax law, a distribution of dividends from income attributable to an Approved
Enterprise will be subject to tax in Israel at the rate of 15%, which is withheld and paid
by the company paying the dividend, if the dividend is distributed during the benefits
period or within the following 12 years (but the 12-year limitation does not apply to a
Foreign Investors Company). Any distribution of dividends from income that is not
attributable to an Approved Enterprise after January 1, 2006, will be subject to tax in
Israel at the rate of 20%.

Under
the U.S.-Israel Tax Treaty, the maximum rate of tax withheld in Israel on dividends paid
to a holder of our ordinary shares who is a U.S. resident (within the meaning of the
U.S.-Israel Tax Treaty) is 25%. However, dividends paid from income derived from our
Approved Enterprise are subject to withholding at the rate of 15%, although we cannot
assure you that we will designate the profits that are being distributed in a way that
will reduce shareholders tax liability according to the U.S.-Israel Tax Treaty.
Furthermore, the maximum rate of withholding tax on dividends, not generated by our
Approved Enterprise, that are paid to a U.S. corporation holding 10% or more of our
outstanding voting capital during the part of the tax year that precedes the date of the
payment of the dividend and during the whole of its prior tax year, is 12.5%. This reduced
rate will not apply if more than 25% of our gross income consists of interest or
dividends, other than dividends or interest received from a subsidiary corporation 50% or
more of the outstanding shares of the voting shares of which are owned by the company.

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A
nonresident of Israel who receives dividends with respect of which tax was fully paid, is
generally exempt from the duty to file returns in Israel in respect of such income,
provided such income was not derived from a business conducted in Israel by the taxpayer,
and the taxpayer has no other taxable sources of income in Israel.

United States Federal
Income Tax Considerations

Subject
to the limitations described herein, this discussion summarizes certain U.S. federal
income tax consequences of the purchase, ownership and disposition of our ordinary shares
to a U.S. holder. A U.S. holder is a holder of our ordinary shares that is:

| |  | an
individual citizen or resident of the U.S. for U.S. federal income tax purposes;
| | - | -----------------------------------------------------------------------------------

| |  | a
corporation (or another entity taxable as a corporation for U.S. federal income tax
purposes) created or                   organized under the laws of the United States or
any political subdivision thereof;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | an
estate, the income of which is subject to U.S. federal income tax regardless of its
source; or
| | - | -------------------------------------------------------------------------------------------------

| |  | a
trust (i) if, in general, a U.S. court is able to exercise primary supervision over its
administration                   and one or more U.S. persons have the authority to
control all of its substantial                   decisions or (ii) that has in effect a
valid election under applicable U.S. Treasury                   Regulations to be treated
as a U.S. person.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

If
a partnership (or any other entity treated as a partnership for U.S. federal income tax
purposes) holds our ordinary shares, the tax treatment of the partnership and a partner in
such partnership will depend on the status of the partner and the activities of the
partnership. Such a partner or partnership should consult its tax advisor as to its
consequences.

Unless
otherwise specifically indicated, this discussion does not consider the U.S. federal
income tax consequences to a person that is not a U.S. holder (a Non-U.S.
holder) and considers only U.S. holders that will own the ordinary shares as capital
assets (generally, for investment).

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This
discussion is based on current provisions of the Internal Revenue Code of 1986, as
amended, referred to as the Code, current and proposed Treasury Regulations promulgated
under the Code and administrative and judicial interpretations of the Code, all as
currently in effect and all of which are subject to change, possibly with a retroactive
effect. This discussion does not address all aspects of U.S. federal income taxation that
may be relevant to any particular U.S. holder based on the U.S. holders individual
circumstances. In particular, this discussion does not address the U.S. federal income tax
consequences to U.S. holders who are broker-dealers or who own, directly, indirectly or
constructively, 10% or more of our outstanding voting shares, U.S. holders holding the
ordinary shares as part of a hedging, straddle or conversion transaction, U.S. holders
whose functional currency is not the U.S. dollar, insurance companies financial service
companies, real estate investment trusts, regulated investment trusts, grantor trusts,
certain former citizens and long-term residents of the United States, tax-exempt
organizations, financial institutions, persons who acquired their ordinary shares upon the
exercise of employee stock options or otherwise as compensation, and persons subject to
the alternative minimum tax, who may be subject to special rules not discussed below.
Additionally, the possible application of U.S. federal estate or gift taxes or any aspect
of state, local or non-U.S. tax laws to a U.S. holder is not discussed below.

You
are advised to consult your tax advisor with respect to the specific U.S. federal, state,
local, and foreign income and other tax consequences to you of purchasing, holding, or
disposing of our ordinary shares.

Taxation
of Distributions on the Ordinary Shares

We
have never paid dividends, and currently do not intend to pay dividends in the future. If
we make distributions in the future, the amount of the distribution with respect to the
ordinary shares will equal the amount of cash and the fair market value of any property
distributed and will also include the amount of any non-U.S. tax withheld, including
Israeli taxes withheld as described above under Taxation  Israeli
Taxation. Subject to the discussion below under Tax Consequences if We are a
Passive Foreign Investment Company, a distribution paid by us with respect to our
ordinary shares to a U.S. holder will be treated as dividend income to the extent that the
distribution does not exceed our current and accumulated earnings and profits, as
determined for U.S. federal income tax purposes. Dividends that are received by U.S.
holders that are individuals, estates or trusts will be taxed at a reduced rate of tax
(currently a maximum rate of 15% for taxable years beginning on or before December 31,
2010), provided that such dividends meet the requirements of qualified dividend
income. Dividends that fail to meet such requirements, and dividends received by
corporate U.S. holders, are taxed at ordinary income rates. No dividend received by a U.S.
holder will be a qualified dividend (1) if the U.S. holder held the ordinary share
with respect to which the dividend was paid for less than 61 days during the 121-day
period beginning on the date that is 60 days before the ex-dividend date with respect to
such dividend, excluding for this purpose, under the rules of Code section 246(c), any
period during which the U.S. holder has an option to sell, is under a contractual
obligation to sell, has made and not closed a short sale of, is the grantor of a
deep-in-the-money or otherwise nonqualified option to buy, or has otherwise diminished its
risk of loss by holding other positions with respect to, such ordinary share (or
substantially identical securities) or (2) to the extent that the U.S. holder is
under an obligation (pursuant to a short sale or otherwise) to make related payments with
respect to positions in property substantially similar or related to the ordinary share
with respect to which the dividend is paid. If we were to be a passive foreign
investment company (as such term is defined in the Code) for any year, dividends
paid on our ordinary shares in such year or in the following year would not be qualified
dividends. In addition, a non-corporate U.S. holder will be able to take a qualified
dividend into account in determining its deductible investment interest (which is
generally limited to its net investment income) only if it elects to do so; in such case
the dividend will be taxed at ordinary income rates.

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The
amount of any distribution that exceeds the amount treated as a dividend will be treated
first as a nontaxable return of capital, reducing the U.S. holders tax basis in its
ordinary shares to the extent thereof, and then as capital gain from the deemed
disposition of the ordinary shares. Corporate holders will not be allowed a deduction for
dividends received in respect of the ordinary shares.

Dividends
paid by us in NIS will be included in the income of U.S. holders at the dollar amount of
the dividend (including any non-U.S. taxes withheld therefrom) based upon the spot rate of
exchange in effect on the date the distribution is included in income. U.S. holders will
have a tax basis in NIS for U.S. federal income tax purposes equal to that dollar value.
Any subsequent gain or loss in respect of NIS arising from exchange rate fluctuations
generally will be taxable as U.S. source ordinary income or loss.

Subject
to the limitations set forth in the Code and the Treasury Regulations thereunder, U.S.
holders may elect to claim as a foreign tax credit against their U.S. federal income tax
liability the non-U.S. income tax withheld from dividends received in respect of the
ordinary shares. The limitations on claiming a foreign tax credit include, among others,
computation rules under which foreign tax credits allowable with respect to specific
classes of income cannot exceed the U.S. federal income taxes otherwise payable with
respect to each such class of income. In this regard, dividends paid by us generally will
be foreign source passive income for U.S. foreign tax credit purposes, U.S.
holders that do not elect to claim a foreign tax credit may instead claim a deduction for
the non-U.S. income tax withheld if they itemize deductions. The rules relating to foreign
tax credits are complex, and you should consult your tax advisor to determine whether and
to what extent you would be entitled to this credit. A U.S. holder will be denied a
foreign tax credit for non-U.S. income tax withheld from a dividend received on the
ordinary shares (i) if the U.S. holder has not held the ordinary shares for at least 16
days of the 31-day period beginning on the date that is 15 days before the ex-dividend
date with respect to such dividend or (ii) to the extent the U.S. holder is under an
obligation to make related payments with respect to positions in substantially similar or
related property. Any days during which a U.S. holder has substantially diminished its
risk of loss on the ordinary shares are not counted toward meeting the required 16-day
holding period.

Taxation
on Disposition of the Ordinary Shares

Subject
to the discussion below under Tax Consequences if We are a Passive Foreign
Investment Company, upon the sale, exchange or other disposition of our ordinary
shares, a U.S. holder will recognize capital gain or loss in an amount equal to the
difference between the amount realized on the disposition and the U.S. holders tax
basis in the ordinary shares. The gain or loss recognized on the disposition will be
long-term capital gain or loss if the U.S. holder held the ordinary shares for more than
one year at the time of the disposition. Long-term capital gains are subject to a maximum
tax of 15% for taxable years beginning on or before December 31, 2010. Gain or loss
recognized by a U.S. holder on a sale, exchange or other disposition of ordinary shares
generally will be treated as U.S. source income or loss for U.S. foreign tax credit
purposes.

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A
U.S. holder that uses the cash method of accounting calculates the dollar value of the
proceeds received on the sale as of the date that the sale settles. However, a U.S. holder
that uses the accrual method of accounting is required to calculate the value of the
proceeds of the sale as of the trade date and may therefore realize foreign currency gain
or loss. A U.S. holder may avoid realizing foreign currency gain or loss by electing to
use the settlement date to determine the proceeds of sale for purposes of calculating the
foreign currency gain or loss. In addition, a U.S. holder that receives foreign currency
upon the disposition of ordinary shares and converts the foreign currency into dollars
after the settlement date or trade date (whichever date the U.S. holder is required to use
to calculate the value of the proceeds of sale) will have foreign exchange gain or loss
based on any appreciation or depreciation in the value of the foreign currency against the
dollar, which generally will be U.S. source ordinary income or loss.

Tax
Consequences If We Are a Passive Foreign Investment Company

We
will be a passive foreign investment company, or PFIC, for a taxable year if either (1)
75% or more of our gross income in the taxable year is passive income or (2) 50% or more
of the value, determined on the basis of a quarterly average, of our assets in the
taxable year produce, or are held for the production of, passive income. If we own
(directly or indirectly) at least 25% by value of the stock of another corporation, we
will be treated for purposes of the foregoing tests as owning our proportionate share of
the other corporations assets and as directly earning our proportionate share of
the other corporations gross income. We believe that in 2006 we were not a PFIC and
currently we expect that we will not be a PFIC in 2007. However, PFIC status is
determined as of the end of the taxable year and is dependent on a number of factors,
including the value of our assets and the amount and type of our gross income. Therefore,
there can be no assurance that we will not become a PFIC for the current fiscal year
ending December 31, 2007 or in any future year. We will notify U.S. holders in the event
we conclude that we will be treated as a PFIC for any taxable year.

If
we are a PFIC, a U.S. holder must determine under which of three alternative taxing
regimes it wishes to be taxed:

| |  | The
QEF regime applies if the U.S. holder elects to treat us as a qualified
electing fund (QEF) for the first taxable year in which the U.S. holder
owns our ordinary shares or in which we are a PFIC, whichever is later, and if we comply
with certain reporting requirements. Under current law, a QEF election cannot be made
with respect to warrants or options to acquire our ordinary shares. If the QEF regime
applies, then each year that we are a PFIC such U.S. holder will include in its gross
income a proportionate share of our ordinary earnings (which is taxed as ordinary income)
and net capital gain (which is taxed as long-term capital gain), subject to a separate
election to defer payment of taxes, which deferral is subject to an interest charge.
These amounts would be included in income by an electing U.S. holder for its taxable year
in which our taxable year ends, whether or not such amounts are actually distributed to
the U.S. holder. A U.S. holders basis in our ordinary shares for which a QEF
election has been made would be increased to reflect the amount of any taxed but
undistributed income. Generally, a QEF election allows an electing U.S. holder to treat
any gain realized on the disposition of his ordinary shares as capital gain.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| | Once
made, the QEF election applies to all subsequent taxable years of the U.S. holder in
which it holds our ordinary shares and for which we are a PFIC, and can be revoked only
with the consent of the United States Internal Revenue Service (IRS). The QEF
election is made by attaching a completed IRS Form 8621, including the PFIC annual
information statement, to a timely filed United States federal income tax return. Even if
a QEF election is not made, a U.S. holder who is a shareholder in a PFIC must file a
completed IRS Form 8621 every year. If we believe we are or will become a PFIC, we will
determine whether we will comply with the reporting requirements that would enable
holders to make a QEF election. If a QEF election is made after the first taxable year in
which a U.S. holder holds our ordinary shares and we are a PFIC, then special rules would
apply.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | A
second regime, the mark-to-market regime, may be elected so long as our
ordinary shares are marketable stock (e.g. regularly traded on
the Nasdaq Global Market). Pursuant to this regime, an electing U.S. holders
ordinary shares are marked-to-market each year that we are a PFIC and the U.S. holder
recognizes as ordinary income or loss an amount equal to the difference as of the close
of the taxable year between the fair market value of our ordinary shares and the U.S.
holders adjusted tax basis therein. Losses are allowed only to the extent of net
mark-to-market gain previously included by the U.S. holder under the election for prior
taxable years. An electing U.S. holders adjusted basis in our ordinary shares is
increased by income recognized under the mark-to-market election and decreased by the
deductions allowed under the election.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Under
the mark-to-market election, gain on the sale of our ordinary shares is treated as
ordinary income, and loss on the sale of our ordinary shares, to the extent the amount of
loss does not exceed the net mark-to-market gain previously included, is treated as
ordinary loss. Under current law, a mark-to-market election cannot be made with respect
to warrants or options to acquire our ordinary shares. The mark-to-market election
applies to the tax year for which the election is made and all subsequent tax years,
unless the ordinary shares cease to be marketable stock or the IRS consents to the
revocation of the election.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | If
the mark-to-market election is made after the first taxable year in which a U.S. holder
holds our ordinary shares and we are a PFIC, then special rules would apply.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | A
U.S. holder making neither the QEF election nor the mark-to-market election is subject to
the excess distribution regime. Under this regime, excess distributions are
subject to special tax rules. An excess distribution is either (1) a distribution with
respect to ordinary shares that is greater than 125% of the average distributions
received by the U.S. holder from us over the shorter of either the preceding three years
or such U.S. holders holding period for our ordinary shares or (2) 100% of the gain
from the disposition of our ordinary shares (including gain deemed recognized if the
ordinary shares are used as security for a loan).
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

86

---

---



| | Excess
distributions must be allocated ratably to each day that a U.S. holder has held our
ordinary shares. A U.S. holder must include amounts allocated to the current taxable year
and to any period prior to the first day of the first taxable year for which we are a
PFIC in its gross income as ordinary income for the current taxable year. All amounts
allocated to other years of the U.S. holder would be taxed at the highest tax rate for
each such other year applicable to ordinary income. The U.S. holder also would be liable
for interest on the deferred tax liability for each such other year calculated as if such
liability had been due with respect to each such other year. The portions of
distributions that are not characterized as excess distributions are subject
to tax in the current year under the normal tax rules of the Code.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | A
U.S. person who inherits shares in a foreign corporation that was a PFIC in the hands of
the decedent is denied the otherwise available step-up in the tax basis of such shares to
fair market value at the date of death.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The
PFIC rules described above are complex. U.S. holders are urged to consult their tax
advisors regarding the application of the PFIC rules, including eligibility for and the
manner and advisability of making, the QEF election or the mark-to-market election.

Non-U.S.
holders of Ordinary Shares

Except
as provided below, a Non-U.S. holder of ordinary shares will not be subject to U.S.
federal income or withholding tax on the receipt of dividends on, and the proceeds from
the disposition of, an ordinary share, unless that item is effectively connected with the
conduct by the Non-U.S. holder of a trade or business in the United States and, in the
case of a resident of a country that has an income tax treaty with the United States, that
item is attributable to a permanent establishment in the United States or, in the case of
an individual, a fixed place of business in the United States. In addition, gain
recognized by an individual Non-U.S. holder will be subject to tax in the United States if
the Non-U.S. holder is present in the United States for 183 days or more in the taxable
year of the sale and other conditions are met.

Information
Reporting and Backup Withholding

A
U.S. holder generally is subject to information reporting and may be subject to backup
withholding at a rate of up to 28% with respect to dividend payments on, and the proceeds
from the disposition of, the ordinary shares. Backup withholding will not apply with
respect to payments made to exempt recipients, including corporations, or if a U.S. holder
provides correct taxpayer identification number (or certifies that he has applied for a
taxpayer identification number), certifies that such holder is not subject to backup
withholding or otherwise establishes an exemption. Backup withholding is not an additional
tax and may be claimed as a credit against the U.S. federal income tax liability of a U.S.
holder, or alternatively, the U.S. holder may be eligible for a refund of any excess
amounts withheld under the backup withholding rules, in either case, provided that the
required information is furnished to theIRS.

87

---

---



Non-U.S.
          holders will generally not be subject to information reporting or backup
          withholding with respect to the payment of dividends on, and the proceeds from
          the disposition of, ordinary shares provided that the Non-U.S. holder provides
          its taxpayer identification number, certifies to its foreign status, or
          otherwise establishes an exemption.

|F. | Dividend
and Paying Agents
|-- | --------------------------

Not applicable.

|G. | Statement
by Experts
|-- | --------------------

Not applicable.

|H. | Documents
on Display
|-- | --------------------

BluePhoenix
is subject to the reporting requirements of the Exchange Act of 1934, as amended, that are
applicable to a foreign private issuer. In accordance with the Exchange Act, we file with
the SEC reports, including annual reports on Form 20-F by June 30 each year. In addition,
we file interim financial information on Form 6-K on a quarterly basis. We also furnish to
the SEC under cover of Form 6-K certain other material information required to be made
public in Israel, filed with and made public by any stock exchange or distributed by us to
our shareholders. You may inspect without charge and copy at prescribed rates such
material at the public reference facilities maintained by the SEC, 100 F Street, N.E.,
Washington, D.C. 20549. You may also obtain copies of such material from the SEC at
prescribed rates by writing to the Public Reference Section of the SEC, 100 F Street,
N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further
information on the public reference room.

The
SEC maintains an Internet site at http://www.sec.gov that contains reports and other
material that are filed through the SECs Electronic Data Gathering, Analysis and
Retrieval (EDGAR) system. BluePhoenix began filing through the EDGAR system
beginning on November 14, 2002.

BluePhoenixs
ordinary shares are quoted on the NASDAQ Global Market. You may inspect reports and other
information concerning BluePhoenix at the offices of the National Association of
Securities Dealers, Inc., 9513 Key West Avenue, Rockville, Maryland 20850. You may also
find our reports filed with the ISA on the Magna site whose address is
http://www.magna.isa.gov.il.

Our
Internet address is http://www.bphx.com. A copy of each report submitted in accordance
with applicable United States law is available for public review at our principal
executive offices.

|I. | Subsidiary
Information
|-- | ----------------------

Not applicable.

88

---

---



# ITEM 11. QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In
light of the nature of our activities, we invest our cash and cash equivalents, in
short-term time deposits. As of December 31, 2006, we invested substantially all of the
cash we held in NIS, dollars, euro and DKK currency accounts. In addition, we had
outstanding loans in dollars and euro. Fluctuations in foreign currency exchange rates,
such as euro or NIS versus the dollar may have a negative impact on our operating results
and financial condition. Accordingly, the interest rates that we pay may also have a major
impact on our financial expenses. Our interest expenses are most sensitive to the changes
in the London Interbank Offered Rate (LIBOR) since most of our borrowings are linked to
the LIBOR. As of December 31, 2006, we had approximately $38.6 million in outstanding
loans, debentures and notes linked to the LIBOR. Depending upon the circumstances, we
enter from time to time into currency and interest options and forward transactions to
decrease the risk of financial exposure from fluctuations in the exchange rate of the
dollar versus any other applicable foreign currencies, and the changes in the LIBOR. As of
December 31, 2006, we were obligated to purchase 5 million euro at an average exchange
rate of 1.285 euro per one dollar and to sell 8 million euro at an average exchange rate
of 1.2948 euro per dollar. As of December 31, 2006, we entered into LIBOR interest forward
transactions for $10.8 million at an average interest rate of 5.08%.

The
table below presents information regarding our borrowings and their expected maturity
dates:

|                             | As at December 31, 2006
|---------------------------- | -----------------------
|
|
|
|
|Liabilities                  |                        
|(US$ equivalent in millions) |                        
|Long term debt:              |                        
|Variable rate (US$)          |                        
|Average interest rate        |                        
|                             |                        
|Interest rate derivatives    |                        
|                             |                        
|Interest rate swaps          |                        
|Variable to fixed (US$)      |                        
|Average pay rate             |                        

# ITEM 12. DESCRIPTION OF
SECURITIES OTHER THAN EQUITY SECURITIES

Not applicable.

89

---

---



# P A R T  II

---

# ITEM 13. DEFAULTS,
DIVIDEND ARREARAGES AND DELINQUENCIES

Not applicable.

# ITEM 14. MATERIAL
MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS

Not applicable.

# ITEM 15. CONTROLS AND
PROCEDURES

(a)
Disclosure Controls and Procedures. Our chief executive officer and chief
          financial officer, after evaluating the effectiveness of our disclosure
controls           and procedures (as defined in Rule 13a-15(e) of the Securities
Exchange Act of           1934, as amended) as of December 31, 2006, have concluded
that, as of such           date, our disclosure controls and procedures were effective to
ensure that           information required to be disclosed by us in reports that we file
or submit           under the Exchange Act is accumulated and communicated to our
management,           including our chief executive officer and chief financial officer,
to allow           timely decisions regarding required disclosure and is recorded,
processed,           summarized and reported within the periods specified by the SECs
rules and           forms.

(b)
Internal Controls. Since the date of the evaluation described above,
          there have been no significant changes in our internal controls over financial
          reporting or in other factors that have materially affected, or are reasonably
          likely to materially affect, our internal control over financial reporting.

# ITEM 16A. AUDIT
COMMITTEE FINANCIAL EXPERT

Our
board of directors has determined that Mr. Michael Chill and Ms. Amira Berkovitz-Amir,
both members of our audit committee, are audit committee financial experts and
are independent as defined by applicable SEC regulations.

90

---

---



# ITEM 16B. CODE OF ETHICS

BluePhoenix
has adopted a code of business conduct and ethics applicable to its executive officers,
directors and all other employees. A copy of the code is available without charge to all
BluePhoenixs employees, investors and others upon request to the following address:
BluePhoenix Solutions Ltd. 8 Maskit St. Herzliya 46120, Israel, Attn: Legal Advisor. Any
waiver of this code for executive officers or directors will be disclosed through the
filing of a Form 6-K.

# ITEM 16C. PRINCIPAL
ACCOUNTANT FEES AND SERVICES

Policy of Preapproval of
Audit and Non-Audit Services of Independent Auditors

Our
audit committee is responsible for the oversight of our independent auditors work.
The audit committees policy is to pre-approve all audit and non-audit services
provided by Ziv Haft independent registered public accounting BDO member firm. These
services may include audit services, audit-related services, tax services and other
services, as further described below. The audit committee sets forth the basis for its
pre-approval in detail, listing the particular services or categories of services that are
pre-approved, and setting forth a specific budget for such services. Additional services
may be pre-approved by the audit committee on an individual basis. Once services have been
pre-approved, Ziv Haft independent registered public accountant BDO member firm and our
management then report to the audit committee on a periodic basis regarding the extent of
services actually provided in accordance with the applicable pre-approval, and regarding
the fees for the services performed.

Principal Accountant Fees
and Services

BluePhoenix
paid the following fees for professional services rendered by Ziv Haft independent
registered certified public accountants (Isr.) and other BDO member firm, for the years
ended December 31, 2005 and 2006:

|                   | 2006 | 2005
|------------------ | ---- | ----
|
|
|
|
|Audit Fees         |      |     
|Audit-Related Fees |      |     
|Tax Fees           |      |     
|All Other Fees     |      |     
|                   |      |     
|Total              |      |     

The
audit fees for the years ended December 31, 2006 and 2005 were for professional services
rendered for the audits of our annual consolidated financial statements, statutory audits
of BluePhoenix and its subsidiaries, issuance of comfort letters, consents and assistance
with review of documents filed with the SEC.

Audit-related
fees are fees for assurance and related services by the independent auditor that are
reasonably related to the performance of the audit or review of the companys
financial statements that are not disclosed under Audit Fees. We had no
Audit-Related Fees in 2006 or 2005.

91

---

---



Tax
fees for the years ended December 31, 2006 and 2005 were for services related to tax
compliance, including the preparation of tax returns and claims for refund, and tax
planning and tax advice, including assistance with tax audits and appeals, tax services
for employee benefit plans and assistance with respect to requests for rulings from tax
authorities.

Other
fees for the year ended December 31, 2006 were for due diligence related to the
acquisition of CodeStream.

# ITEM 16D. EXEMPTIONS
FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES

Not applicable.

# ITEM 16E. PURCHASES OF
EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS

Not applicable.

# P A R T  III

---

# ITEM 17. FINANCIAL
STATEMENTS

We
have responded to Item 18 in lieu of this item.

# ITEM 18. FINANCIAL
STATEMENTS

The
financial statements required by this item are found at the end of this annual report,
beginning on page F-1.

# ITEM 19. EXHIBITS

# Exhibit No.

|1.1 |  | English
translation of the Memorandum of Association as amended on July 23, 2003(1)
|--- |  | -----------------------------------------------------------------------------------

|1.2 |  | Articles
of Association as amended on December 27, 2005(2)
|--- |  | ----------------------------------------------------------

|4.1 |  | Agreement
dated January 11, 2001 among the Registrant, the Israel Mezzanine Fund L.P., The
                        Israel Mezzanine Fund, The Jordan (Bermuda) Investment Company
Ltd.(3)
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

92

---

---



# Exhibit No.

|4.2 |  | Amendment
dated August 7, 2003 to agreement among the Registrant, the Israel Mezzanine Fund
                        L.P., The Israel Mezzanine Fund and The Jordan (Bermuda)
Investment Company Ltd. dated January                         11, 2001 (4)
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.3 |  | Share
Purchase Agreement dated March 30, 2004, among the Registrant and four institutional
                        investors in connection with a $5 million private placement(5)
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.4 |  | Amendment
dated February 18, 2005 to Share Purchase Agreement among the Registrant and four
                        institutional investors in connection with a $5 million private
placement(5)
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.5 |  | Registration
Rights Agreement dated March 30, 2004, among the Registrant and four institutional
                        investors in connection with a $5 million private placement(5)
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.6 |  | The
1996 Share Option Plan - Part One, as amended on January 28, 1997, December 5, 1999,
December                        18, 2000, December 26, 2000 and August 6, 2003(4)
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.7 |  | Agreement
dated January 1, 1996 between the Registrant and Argotec Ltd.(6)
|--- |  | --------------------------------------------------------------------------

|4.8 |  | English
translation of Loan Agreement between Liraz Systems Ltd. and Arie Kilman dated April 2000
                       as amended by the Addendum dated April 2002(4)
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.9 |  | Form
of Indemnification Letter dated December 27, 2005 between the Registrant and certain
office                        holders(2)
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------

|4.10 |  | Summary
of credit line Letter Agreement between the Registrant and Bank Leumi Le'Israel
                       Ltd.(4)
|---- |  | ----------------------------------------------------------------------------------------------------------------------

|4.11 |  | Master
Services Agreement between BluePhoenix Solutions Nordic AS and SDC Udvikling A/S dated
                       October 1, 2002(2)
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------

|4.12 |  | Agreement
dated December 14, 2006  among the registrant, CodeStream Software Ltd. and certain
                       shareholders of CodeStream Software Ltd.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.13 |  | English
translation of cooperation agreement dated August 8, 2006 between Matrix IT Ltd. and the
                       Registrant
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------

|8 |  | List
of Subsidiaries
|- |  | --------------------

|12.1 |  | Certification
of the Chief Executive Officer pursuant to §302 of the Sarbanes-Oxley Act
|---- |  | ---------------------------------------------------------------------------------------

|12.2 |  | Certification
of the Chief Financial Officer pursuant to §302 of the Sarbanes-Oxley Act
|---- |  | ---------------------------------------------------------------------------------------

93

---

---



# Exhibit No.

|13.1 |  | Certification
of the Chief Executive Officer pursuant to 18 U.S.C. §1350, as adopted pursuant to
                     §906 of the Sarbanes-Oxley Act
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------

|13.2 |  | Certification
of the Chief Financial Officer pursuant to 18 U.S.C. §1350, as adopted pursuant to
                     §906 of the Sarbanes-Oxley Act
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------

|15 |  | Consent
of Ziv Haft registered certified public accountants (Isr.) BDO member firm
|-- |  | ----------------------------------------------------------------------------------

---

(1)                      Incorporated
by reference to the Registration Statement on Form F-1 filed with                     the
Securities and Exchange Commission on December 24, 1996.

(2)                      Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on March 27, 2006.

(3) Incorporated by
reference to the Registrant annual report on Form 20-F                filed with the
Securities and Exchange Commission on June 29, 2001.

(4)                      Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 1, 2004, as amended on
                    November 9, 2004.

(5) Incorporated
by reference to the Registration Statement on Form F-3                filed with the
Securities and Exchange Commission on June 1, 2004, as amended on                November
9, 2004 and on February 18, 2005.

(6) Incorporated
by reference to Amendment No. 1 to the Registration                Statement on Form F-1
filed with the Securities and Exchange Commission on                January 28, 1997.

94

---

---



SIGNATURES

The registrant hereby certifies that
it meets all of the requirements for filing on Form 20-F and that it has duly caused and
authorized the undersigned to sign this annual report on its behalf.

| |  | BLUEPHOENIX SOLUTIONS LTD.(Registrant)By: /s/ Iris Yahal
Iris YahalChief Financial Officer
| |  | --------------------------------------------------------------------------------------------------------

Date: March 29, 2007



---

---



# EXHIBIT INDEX

# Exhibit No.

|1.1 |  | English
translation of the Memorandum of Association as amended on July 23, 2003(1)
|--- |  | -----------------------------------------------------------------------------------

|1.2 |  | Articles
of Association as amended on December 27, 2005(2)
|--- |  | ----------------------------------------------------------

|4.1 |  | Agreement
dated January 11, 2001 among the Registrant, the Israel Mezzanine Fund L.P., The
                        Israel Mezzanine Fund, The Jordan (Bermuda) Investment Company
Ltd.(3)
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.2 |  | Amendment
dated August 7, 2003 to agreement among the Registrant, the Israel Mezzanine Fund
                        L.P., The Israel Mezzanine Fund and The Jordan (Bermuda)
Investment Company Ltd. dated January                         11, 2001 (4)
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.3 |  | Share
Purchase Agreement dated March 30, 2004, among the Registrant and four institutional
                        investors in connection with a $5 million private placement(5)
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.4 |  | Amendment
dated February 18, 2005 to Share Purchase Agreement among the Registrant and four
                        institutional investors in connection with a $5 million private
placement(5)
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.5 |  | Registration
Rights Agreement dated March 30, 2004, among the Registrant and four institutional
                        investors in connection with a $5 million private placement(5)
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.6 |  | The
1996 Share Option Plan - Part One, as amended on January 28, 1997, December 5, 1999,
December                        18, 2000, December 26, 2000 and August 6, 2003(4)
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.7 |  | Agreement
dated January 1, 1996 between the Registrant and Argotec Ltd.(6)
|--- |  | --------------------------------------------------------------------------

|4.8 |  | English
translation of Loan Agreement between Liraz Systems Ltd. and Arie Kilman dated April 2000
                       as amended by the Addendum dated April 2002(4)
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.9 |  | Form
of Indemnification Letter dated December 27, 2005 between the Registrant and certain
office                        holders(2)
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------

|4.10 |  | Summary
of credit line Letter Agreement between the Registrant and Bank Leumi Le'Israel
                       Ltd.(4)
|---- |  | ----------------------------------------------------------------------------------------------------------------------

|4.11 |  | Master
Services Agreement between BluePhoenix Solutions Nordic AS and SDC Udvikling A/S dated
                       October 1, 2002(2)
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------

|4.12 |  | Agreement
dated December 14, 2006  among the registrant, CodeStream Software Ltd. and certain
                       shareholders of CodeStream Software Ltd.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.13 |  | English
translation of cooperation agreement dated August 8, 2006 between Matrix IT Ltd. and the
                       Registrant
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------



---

---



|8 |  | List
of Subsidiaries
|- |  | --------------------

|12.1 |  | Certification
of the Chief Executive Officer pursuant to §302 of the Sarbanes-Oxley Act
|---- |  | ---------------------------------------------------------------------------------------

|12.2 |  | Certification
of the Chief Financial Officer pursuant to §302 of the Sarbanes-Oxley Act
|---- |  | ---------------------------------------------------------------------------------------

|13.1 |  | Certification
of the Chief Executive Officer pursuant to 18 U.S.C. §1350, as adopted pursuant to
                     §906 of the Sarbanes-Oxley Act
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------

|13.2 |  | Certification
of the Chief Financial Officer pursuant to 18 U.S.C. §1350, as adopted pursuant to
                     §906 of the Sarbanes-Oxley Act
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------

|15 |  | Consent
of Ziv Haft registered certified public accountants (Isr.) BDO member firm
|-- |  | ----------------------------------------------------------------------------------

---

(1)                      Incorporated
by reference to the Registration Statement on Form F-1 filed with                     the
Securities and Exchange Commission on December 24, 1996.

(2)                      Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on March 27, 2006.

(3) Incorporated by
reference to the Registrant annual report on Form 20-F                filed with the
Securities and Exchange Commission on June 29, 2001.

(4)                      Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 1, 2004, as amended on
                    November 9, 2004.

(5) Incorporated
by reference to the Registration Statement on Form F-3                filed with the
Securities and Exchange Commission on June 1, 2004, as amended on                November
9, 2004 and on February 18, 2005.

(6) Incorporated
by reference to Amendment No. 1 to the Registration                Statement on Form F-1
filed with the Securities and Exchange Commission on                January 28, 1997.



---

---

BLUEPHOENIX SOLUTIONS LTD.
2006 Annual Report



---

---



BLUEPHOENIX SOLUTIONS LTD.2006 CONSOLIDATED FINANCIAL STATEMENTS


TABLE OF CONTENTS

|                                                          |  |               
|--------------------------------------------------------- |  | --------------
|                                                          |  | Page          
|                                                          |  |               
|Report of Independent Registered Public
  Accounting Firm |  | F  1         
|                                                          |  |               
|Consolidated Financial Statements:                        |  |               
|                                                          |  |               
|Balance Sheets                                            |  | F  2         
|                                                          |  |               
|Statements of Operations                                  |  | F  3         
|                                                          |  |               
|Statements of Changes in Shareholders Equity             |  | F  4         
|                                                          |  |               
|Statements of Cash Flows                                  |  | F  5  F  6 
|                                                          |  |               
|Notes to Consolidated Financial Statements                |  | F  7  F  53

The amounts are stated in U.S. dollars ($).

|
|
|
|
|
|
|



---

---



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM
To the Shareholders and Board of Directors of
BLUEPHOENIX SOLUTIONS LTD.

We have
audited the accompanying consolidated balance sheets of BluePhoenix Solutions
Ltd. (the Company) and its subsidiaries as of December 31, 2006 and 2005 and
the related consolidated statements of operations, changes in shareholders
equity and cash flows for each of the three years in the period ended December
31, 2006. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted
our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audits included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Companys internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our
opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of the
Company and its subsidiaries as of December 31, 2006 and 2005, and the related
consolidated results of its operations and cash flows for each of the three
years in the period ended December 31, 2006, in conformity with accounting
principles generally accepted in the United States of America.

As discussed
in Note 2J to the consolidated financial statements, the Company changed the
manner in which it accounts for share-based compensation effective January 1,
2006 to conform with FASB Statement of Financial Accounting Standards No. 123
(revised 2004), Share-Based Payment.

Tel Aviv, Israel
March 30, 2007

| |                                    
| | -----------------------------------
| | Ziv Haft                           
| | Certified Public Accountants (Isr.)
| | BDO Member Firm                    

F  1

---

---



BLUEPHOENIX SOLUTIONS LTD.CONSOLIDATED BALANCE SHEETS

|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------- | ---- | - | ------- | -
|                                                                                                                                                                                                           |  | December 31,   |        
|                                                                                                                                                                                                           |  |                |        
|                                                                                                                                                                                                           |  | 2006           |         | 2005 |  
|                                                                                                                                                                                                           |  |                |         |      |  
|                                                                                                                                                                                                           |  | (in thousands) |        
|                                                                                                                                                                                                           |  |                |        
|ASSETS                                                                                                                                                                                                     |  |                |         |      |   |         |  
|CURRENT ASSETS (Note 12):                                                                                                                                                                                  |  |                |         |      |   |         |  
|Cash and cash equivalents                                                                                                                                                                                  |  | $              | 11,627  |      | $ | 10,791  |  
|Marketable securities                                                                                                                                                                                      |  |                | 1,053   |      |   | -       |  
|Trade accounts receivable (Note 14A1)                                                                                                                                                                      |  |                | 26,489  |      |   | 18,143  |  
|Other current assets (Note 14A2)                                                                                                                                                                           |  |                | 3,096   |      |   | 2,495   |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|Total current assets                                                                                                                                                                                       |  |                | 42,265  |      |   | 31,429  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|LONG-TERM TRADE RECIVABLES                                                                                                                                                                                 |  |                | 1,390   |      |   | -       |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|INVESTMENTS IN AFFILIATES AND OTHER
COMPANIES                                                                                                                                                              |  |                | -       |      |   | 370     |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|PROPERTY AND EQUIPMENT, NET (Note
3)                                                                                                                                                                       |  |                | 2,147   |      |   | 2,160   |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|                                                                                                                                                                                                          
|GOODWILL (Note 4)                                                                                                                                                                                          |  |                | 44,838  |      |   | 38,832  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|SOFTWARE DEVELOPMENT COSTS AND OTHER (Note
5)                                                                                                                                                              |  |                | 36,826  |      |   | 26,900  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|Total assets                                                                                                                                                                                               |  | $              | 127,466 |      | $ | 99,691  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|LIABILITIES AND SHAREHOLDERS
EQUITY                                                                                                                                                                       |  |                |         |      |   |         |  
|CURRENT LIABILITIES (Note 12):                                                                                                                                                                             |  |                |         |      |   |         |  
|Short-term bank credit and others (Note
6)                                                                                                                                                                 |  | $              | 609     |      | $ | 14,095  |  
|Convertible debentures                                                                                                                                                                                     |  |                | 4,482   |      |   | -       |  
|Accounts payable and accruals:                                                                                                                                                                             |  |                |         |      |   |         |  
|Trade                                                                                                                                                                                                      |  |                | 4,594   |      |   | 3,088   |  
|Deferred revenue                                                                                                                                                                                           |  |                | 7,790   |      |   | 2,776   |  
|Other (Note 14A3)                                                                                                                                                                                          |  |                | 6,929   |      |   | 6,924   |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|Total current liabilities                                                                                                                                                                                  |  |                | 24,404  |      |   | 26,883  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|LONG-TERM LIABILITIES:                                                                                                                                                                                     |  |                |         |      |   |         |  
|Convertible debentures (Note 11B2,
11B3)                                                                                                                                                                   |  |                | 14,049  |      |   | 4,342   |  
|Accrued severance pay, net (Note 7)                                                                                                                                                                        |  |                | 1,718   |      |   | 1,309   |  
|Provision for losses in formerly-consolidated
subsidiary (Note 8)                                                                                                                                          |  |                | 1,971   |      |   | 1,971   |  
|Loans from banks and others (Note 9)                                                                                                                                                                       |  |                | 20,027  |      |   | 8,389   |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|Total long-term liabilities                                                                                                                                                                                |  |                | 37,765  |      |   | 16,011  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|MINORITY INTERESTS                                                                                                                                                                                         |  |                | 5,348   |      |   | 5,031   |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|COMMITMENTS AND CONTINGENCIES (Note
10)                                                                                                                                                                    |  |                |         |      |   |         |  
|SHAREHOLDERS EQUITY (Note
11):                                                                                                                                                                            |  |                |         |      |   |         |  
|Share capital - ordinary shares of NIS 0.01 par
value (authorized:
  December 31, 2006 and 2005 - 30,000,000 shares; issued: December 31, 2006
  15,945,952 shares; December 31, 2005 - 15,430,403 shares) |  |                | 31      |      |   | 31      |  
|Additional paid-in capital                                                                                                                                                                                 |  |                | 58,556  |      |   | 56,205  |  
|Accumulated other comprehensive loss                                                                                                                                                                       |  |                | (1,537  | )    |   | (1,537  | )
|Retained earnings                                                                                                                                                                                          |  |                | 16,447  |      |   | 11,775  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|                                                                                                                                                                                                           |  |                | 73,497  |      |   | 66,474  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|Cost of 1,647,594 Company shares held by
subsidiaries (December
  31, 2005  1,870,565 shares)                                                                                                             |  |                | (13,548 | )    |   | (14,708 | )
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|                                                                                                                                                                                                          
|Total shareholders equity                                                                                                                                                                                 |  |                | 59,949  |      |   | 51,766  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  
|Total liabilities and shareholders
equity                                                                                                                                                                 |  | $              | 127,466 |      | $ | 99,691  |  
|                                                                                                                                                                                                           |  |                |         |      |   |         |  

F  2

---

---



BLUEPHOENIX SOLUTIONS
LTD.CONSOLIDATED STATEMENTS OF OPERATIONS

|                                                            |  |                                       |        |      |   |        |   |   |        |  
|----------------------------------------------------------- |  | ------------------------------------- | ------ | ---- | - | ------ | - | - | ------ | -
|                                                            |  | Year ended December 31,               |       
|                                                            |  |                                       |       
|                                                            |  | 2006                                  |        | 2005 |   | 2004   |  
|                                                            |  |                                       |        |      |   |        |  
|                                                            |  | (in thousands, except per share data) |       
|                                                            |  |                                       |       
|                                                            |  |                                       |       
|Revenues (Note 14B1)                                        |  | $                                     | 68,004 |      | $ | 58,947 |   | $ | 57,186 |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Cost of revenues                                            |  |                                       | 28,515 |      |   | 25,379 |   |   | 24,253 |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Gross profit                                                |  |                                       | 39,489 |      |   | 33,568 |   |   | 32,933 |  
|                                                           
|Software development
  costs, net                           |  |                                       | 9,400  |      |   | 8,006  |   |   | 8,055  |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Selling, general, and
  administrative expenses             |  |                                       | 22,149 |      |   | 21,611 |   |   | 21,388 |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Operating income                                            |  |                                       | 7,940  |      |   | 3,951  |   |   | 3,490  |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Financial expenses, net
  (Note 14B3)                       |  |                                       | (3,515 | )    |   | (1,978 | ) |   | (882   | )
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Gain on realization of
  shareholdings (Note 14B4)          |  |                                       | -      |      |   | -      |   |   | 112    |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Other income, net (Note
  14B5)                             |  |                                       | 282    |      |   | 104    |   |   | 975    |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Income before taxes on
income                               |  |                                       | 4,707  |      |   | 2,077  |   |   | 3,695  |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Taxes on income (benefit)
  (Note 13)                       |  |                                       | (282   | )    |   | 149    |   |   | 260    |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|                                                            |  |                                       | 4,989  |      |   | 1,928  |   |   | 3,435  |  
|Share in losses of
  affiliated companies, net              |  |                                       | -      |      |   | -      |   |   | (516   | )
|                                                           
|Minority interest in
  profits of subsidiaries              |  |                                       | (317   | )    |   | (139   | ) |   | (73    | )
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Net income                                                  |  | $                                     | 4,672  |      | $ | 1,789  |   | $ | 2,846  |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Earnings
  per share (Note 14C):                            |  |                                       |        |      |   |        |   |   |        |  
|                                                           
|Basic                                                       |  | $                                     | 0.34   |      | $ | 0.13   |   | $ | 0.21   |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Diluted                                                     |  | $                                     | 0.33   |      | $ | 0.13   |   | $ | 0.21   |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Weighted
  average number of shares outstanding (Note 14C): |  |                                       |        |      |   |        |   |   |        |  
|                                                           
|Basic                                                       |  |                                       | 13,889 |      |   | 13,557 |   |   | 13,523 |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  
|Diluted                                                     |  |                                       | 14,371 |      |   | 13,960 |   |   | 14,679 |  
|                                                            |  |                                       |        |      |   |        |   |   |        |  

The accompanying notes are an integral part of the
consolidated financial statements.

F  3

---

---



BLUEPHOENIX SOLUTIONS LTD.

CONSOLIDATED
STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY

|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|------------------------------------------------------------------ |  | ----------------------------- | ---------- | --------- | - | -------------------------------- |  | --------------------------------------------- | ------ | -------------------- | - | --------------------------------------------------- | - | ----- | ------ |  | - | ------- | - | - | ------ | -
|                                                                   |  | Share capital                 |            |           |   |                                  |  |                                               |        |                      |   |                                                     |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |  
|                                                                   |  | Number of
  shares            |            | Par value |   | Additional 
  paid-in 
  capital |  | Accumulated 
  other 
  comprehensive 
  loss |        | Retained 
  earnings |   | Cost of
  Company 
  shares held by 
  subsidiaries |   | Total |       
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |       
|                                                                   |  | (in thousands, except shares) |           
|                                                                   |  |                               |           
|                                                                  
|Balance at December 31, 2003                                       |  |                               | 13,484,276 |           | $ | 30                               |  | $                                             | 54,412 |                      | $ | (1,476                                              | ) | $     | 7,140  |  | $ | (14,708 | ) | $ | 45,398 |  
|Changes during 2004:                                               |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Components of comprehensive income:                                |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Net income                                                         |  |                               | -          |           |   | -                                |  |                                               | -      |                      |   | -                                                   |   |       | 2,846  |  |   | -       |   |   | 2,846  |  
|Currency translation adjustments                                   |  |                               | -          |           |   | -                                |  |                                               | -      |                      |   | (155                                                | ) |       | -      |  |   | -       |   |   | (155   | )
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Total
  comprehensive income                                       |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   | 2,691  |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Issuance of shares                                                 |  |                               | 31,496     |           |   | 1                                |  |                                               | 199    |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 200    |  
|Issuance of options                                                |  |                               | -          |           |   | -                                |  |                                               | 48     |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 48     |  
|Beneficial conversion features                                     |  |                               | -          |           |   | -                                |  |                                               | 173    |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 173    |  
|Exercise of employee share options                                 |  |                               | 33,767     |           |   | *-                               |  |                                               | 121    |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 121    |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Balance at December 31, 2004                                       |  |                               | 13,549,539 |           |   | 31                               |  |                                               | 54,953 |                      |   | (1,631                                              | ) |       | 9,986  |  |   | (14,708 | ) |   | 48,631 |  
|Changes during 2005:                                               |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Components of comprehensive income:                                |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Net income                                                         |  |                               | -          |           |   | -                                |  |                                               | -      |                      |   | -                                                   |   |       | 1,789  |  |   | -       |   |   | 1,789  |  
|Currency translation adjustments                                   |  |                               | -          |           |   | -                                |  |                                               | -      |                      |   | 94                                                  |   |       | -      |  |   | -       |   |   | 94     |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Total
  comprehensive income                                       |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   | 1,883  |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Issuance of options                                                |  |                               | -          |           |   | -                                |  |                                               | 48     |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 48     |  
|Change in fair value of a conversion feature upon
modification     |  |                               | -          |           |   | -                                |  |                                               | 325    |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 325    |  
|Classification of warrants to equity                               |  |                               | -          |           |   | -                                |  |                                               | 848    |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 848    |  
|Exercise of employee share options                                 |  |                               | 10,299     |           |   | *-                               |  |                                               | 31     |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 31     |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Balance at December 31, 2005                                       |  |                               | 13,559,838 |           |   | 31                               |  |                                               | 56,205 |                      |   | (1,537                                              | ) |       | 11,775 |  |   | (14,708 | ) |   | 51,766 |  
|Changes during 2006:                                               |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Components of comprehensive income:                                |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Net income                                                         |  |                               | -          |           |   | -                                |  |                                               | -      |                      |   | -                                                   |   |       | 4,672  |  |   | -       |   |   | 4,672  |  
|Currency translation adjustments                                   |  |                               | -          |           |   | -                                |  |                                               | -      |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | -      |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Total
  comprehensive income                                       |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   | 4,672  |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Issuance of options                                                |  |                               | -          |           |   | -                                |  |                                               | 48     |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 48     |  
|Stock-based compensation                                           |  |                               | -          |           |   | -                                |  |                                               | 40     |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 40     |  
|Conversion of convertible debentures                               |  |                               | 257,133    |           |   | *                                |  |                                               | 1,164  |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 1,164  |  
|Sale of shares held by a subsidiary                                |  |                               | 136,000    |           |   | *                                |  |                                               | 42     |                      |   | -                                                   |   |       | -      |  |   | 492     |   |   | 534    |  
|Issuance of shares in respect of acquisition of
activity (Note 2D) |  |                               | 138,591    |           |   | *                                |  |                                               | (37    | )                    |   | -                                                   |   |       | -      |  |   | 668     |   |   | 631    |  
|Classification of warrants to equity                               |  |                               | -          |           |   | -                                |  |                                               | 364    |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 364    |  
|Exercise of employee share options                                 |  |                               | 206,796    |           |   | *                                |  |                                               | 730    |                      |   | -                                                   |   |       | -      |  |   | -       |   |   | 730    |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  
|Balance at December 31, 2006                                       |  |                               | 14,298,358 |           | $ | 31                               |  | $                                             | 58,556 |                      | $ | (1,537                                              | ) | $     | 16,447 |  | $ | (13,548 | ) | $ | 59,949 |  
|                                                                   |  |                               |            |           |   |                                  |  |                                               |        |                      |   |                                                     |   |       |        |  |   |         |   |   |        |  

|  |                       
|- | ----------------------
|* | Less than $1 thousand.

The accompanying notes are an integral part
of the consolidated financial statements.

F  4

---

---



BLUEPHOENIX SOLUTIONS LTD.CONSOLIDATED
STATEMENTS OF CASH FLOWS

|                                                                                            |  |                         |         |      |   |         |   |   |        |  
|------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | ---- | - | ------- | - | - | ------ | -
|                                                                                            |  | Year ended December 31, |        
|                                                                                            |  |                         |        
|                                                                                            |  | 2006                    |         | 2005 |   | 2004    |  
|                                                                                            |  |                         |         |      |   |         |  
|                                                                                            |  | (in thousands)          |        
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                       |  |                         |         |      |   |         |   |   |        |  
|Net income                                                                                  |  | $                       | 4,672   |      | $ | 1,789   |   | $ | 2,846  |  
|Adjustments to reconcile net
  income to net cash provided by operating activities:         |  |                         |         |      |   |         |   |   |        |  
|Minority interests in profits of
  subsidiaries                                             |  |                         | 317     |      |   | 139     |   |   | 73     |  
|Share in losses of affiliated companies,
  net                                              |  |                         | -       |      |   | -       |   |   | 516    |  
|Depreciation and amortization                                                               |  |                         | 8,481   |      |   | 7,001   |   |   | 4,430  |  
|Increase (decrease) in accrued severance
  pay, net                                         |  |                         | 409     |      |   | (343    | ) |   | (362   | )
|Loss (gain) on sale of property and
  equipment                                             |  |                         | (32     | )    |   | (35     | ) |   | 14     |  
|Gain on realization of shareholdings and
  expiration of options                            |  |                         | -       |      |   | -       |   |   | (112   | )
|Change in value of long term-loans and
  liabilities                                        |  |                         | 1,853   |      |   | 410     |   |   | 275    |  
|Stock  based compensation                                                                  |  |                         | 40      |      |   | -       |   |   | -      |  
|Deferred income taxes, net                                                                  |  |                         | 13      |      |   | 58      |   |   | (104   | )
|Changes in operating assets and
  liabilities:                                              |  |                         |         |      |   |         |   |   |        |  
|Increase (decrease) in marketable
  securities                                              |  |                         | (715    | )    |   | 177     |   |   | 600    |  
|Increase in trade receivables                                                               |  |                         | (9,731  | )    |   | (1,221  | ) |   | (2,011 | )
|Decrease (increase) in other current
assets                                                 |  |                         | (909    | )    |   | 544     |   |   | (335   | )
|Increase (decrease) in trade payables                                                       |  |                         | 1,390   |      |   | (1,939  | ) |   | 437    |  
|Increase (decrease) in other accounts
  payable                                             |  |                         | 4,186   |      |   | (1,388  | ) |   | (5,138 | )
|                                                                                            |  |                         |         |      |   |         |   |   |        |  
|Net cash provided by operating
activities                                                   |  |                         | 9,974   |      |   | 5,192   |   |   | 1,129  |  
|                                                                                            |  |                         |         |      |   |         |   |   |        |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                       |  |                         |         |      |   |         |   |   |        |  
|Purchase of property and equipment                                                          |  |                         | (676    | )    |   | (700    | ) |   | (1,118 | )
|Proceeds from sale of property and
  equipment                                              |  |                         | 161     |      |   | 277     |   |   | 203    |  
|Investment and loans to affiliated and
  other companies                                    |  |                         | -       |      |   | (370    | ) |   | (97    | )
|Repayment of loan                                                                           |  |                         | -       |      |   | -       |   |   | 68     |  
|Proceeds from sale of investments                                                           |  |                         | -       |      |   | -       |   |   | 2,777  |  
|Capitalization of software development and
  other costs                                    |  |                         | (8,259  | )    |   | (8,117  | ) |   | (7,117 | )
|Purchase of minority interest in
  subsidiaries and purchase of activity                    |  |                         | (1,118  | )    |   | (180    | ) |   | -      |  
|Investment in newly-consolidated
  subsidiaries and purchase of newly-activity (Appendix A) |  |                         | (13,224 | )    |   | (1,343  | ) |   | (95    | )
|                                                                                            |  |                         |         |      |   |         |   |   |        |  
|Net cash used in investing activities                                                       |  |                         | (23,116 | )    |   | (10,433 | ) |   | (5,379 | )
|                                                                                            |  |                         |         |      |   |         |   |   |        |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                       |  |                         |         |      |   |         |   |   |        |  
|Short-term bank credit, net                                                                 |  |                         | (14,013 | )    |   | 153     |   |   | (2,350 | )
|Repayment of long-term loans                                                                |  |                         | (1,149  | )    |   | (542    | ) |   | (2,063 | )
|Receipt of long-term loans                                                                  |  |                         | 14,391  |      |   | 7,003   |   |   | 2,443  |  
|Issuance of convertible debentures and
  warrants                                           |  |                         | 14,140  |      |   | -       |   |   | 5,000  |  
|Debentures issuance costs                                                                   |  |                         | (655    | )    |   | -       |   |   | (643   | )
|Exercise of employee share options                                                          |  |                         | 730     |      |   | 31      |   |   | 121    |  
|Sale of shares held by a subsidiary                                                         |  |                         | 534     |      |   | -       |   |   | -      |  
|                                                                                            |  |                         |         |      |   |         |   |   |        |  
|Net cash provided by financing
activities                                                   |  |                         | 13,978  |      |   | 6,645   |   |   | 2,508  |  
|                                                                                            |  |                         |         |      |   |         |   |   |        |  
|EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH                                             |  |                         | -       |      |   | 24      |   |   | -      |  
|                                                                                            |  |                         |         |      |   |         |   |   |        |  
|NET INCREASE
  (DECREASE) IN CASH AND CASH EQUIVALENTS                                      |  |                         | 836     |      |   | 1,428   |   |   | (1,742 | )
|CASH AND
  CASH EQUIVALENTS AT BEGINNING OF YEAR                                            |  |                         | 10,791  |      |   | 9,363   |   |   | 11,105 |  
|                                                                                            |  |                         |         |      |   |         |   |   |        |  
|CASH AND
  CASH EQUIVALENTS AT END OF YEAR                                                  |  | $                       | 11,627  |      | $ | 10,791  |   | $ | 9,363  |  
|                                                                                            |  |                         |         |      |   |         |   |   |        |  

The accompanying notes are
an integral part of the consolidated financial statements.

F  5

---

---



BLUEPHOENIX
SOLUTIONS LTD.CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                                    |  |                         |       |      |   |       |  |   |       | 
|--------------------------------------------------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | ----- | 
|                                                    |  | Year ended December 31, |      
|                                                    |  |                         |      
|                                                    |  | 2006                    |       | 2005 |   | 2004  | 
|                                                    |  |                         |       |      |   |       | 
|                                                    |  | (in thousands)          |      
|                                                    |  |                         |      
|SUPPLEMENTAL
  DISCLOSURE OF CASH FLOW INFORMATION: |  |                         |       |      |   |       |  |   |       | 
|                                                   
|Cash paid during the year for:                      |  |                         |       |      |   |       |  |   |       | 
|                                                   
|Income taxes                                        |  | $                       | 239   |      | $ | 1,221 |  | $ | 1,316 | 
|                                                   
|Interest                                            |  | $                       | 1,473 |      | $ | 864   |  | $ | 443   | 

APPENDIX A  INVESTMENT IN
NEWLY-CONSOLIDATED SUBSIDIARIES AND PURCHASE OF ACTIVITY:

|                                               |  |                         |         |      |   |        |   |   |        |  
|---------------------------------------------- |  | ----------------------- | ------- | ---- | - | ------ | - | - | ------ | -
|                                               |  | Year ended December 31, |        
|                                               |  |                         |        
|                                               |  | 2006                    |         | 2005 |   | 2004   |  
|                                               |  |                         |         |      |   |        |  
|                                               |  | (in thousands)          |        
|                                               |  |                         |        
|Working capital, other
  than cash             |  | $                       | 1,486   |      | $ | 105    |   | $ | 2,631  |  
|Investment and loans to
  affiliated Company   |  |                         | 370     |      |   | -      |   |   | 27     |  
|Property and equipment                         |  |                         | (289    | )    |   | (100   | ) |   | (373   | )
|Minority interests                             |  |                         | -       |      |   | -      |   |   | 98     |  
|Customer related
  intangible assets and other |  |                         | -       |      |   | (564   | ) |   | (425   | )
|Goodwill                                       |  |                         | (5,778  | )    |   | -      |   |   | (283   | )
|Capitalized software
  development costs       |  |                         | (8,077  | )    |   | (1,158 | ) |   | (6,056 | )
|                                               |  |                         |         |      |   |        |   |   |        |  
|Customer relations intangible
  asset          |  |                         | (470    | )    |   | -      |   |   | -      |  
|Non-current liabilities                        |  |                         | (466    | )    |   | 374    |   |   | 4,086  |  
|Company shares issued upon
  acquisition       |  |                         | -       |      |   | -      |   |   | 200    |  
|                                               |  |                         |         |      |   |        |   |   |        |  
|Net cash used in acquisition                   |  | $                       | (13,224 | )    | $ | (1,343 | ) | $ | (95    | )
|                                               |  |                         |         |      |   |        |   |   |        |  

APPENDIX B  NON-CASH
ACTIVITIES:

|                                                |  |                         |       |      |   |       |  |   |   | 
|----------------------------------------------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | - | 
|                                                |  | Year ended December 31, |      
|                                                |  |                         |      
|                                                |  | 2006                    |       | 2005 |   | 2004  | 
|                                                |  |                         |       |      |   |       | 
|                                                |  | (in thousands)          |      
|                                                |  |                         |      
|                                                |  |                         |       |      |   |       |  |   |   | 
|Investment in subsidiaries                      |  | $                       | 275   |      | $ | 1,577 |  | $ | - | 
|Purchase of minority
  interest in subsidiaries |  | $                       | -     |      | $ | 100   |  | $ | - | 
|Conversion of convertible
  debentures          |  | $                       | 1,164 |      | $ | -     |  | $ | - | 

The accompanying notes are an integral part
of the consolidated financial statements.

F  6

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting Policies:

|   |                                                                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-- | ------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | General:                                                                             
|   |                                                                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | The significant accounting
  policies, applied on a consistent basis, are as follows:
|   |                                                                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | 1.                                                                                    | The Company:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                       | BluePhoenix Solutions Ltd.
  (BluePhoenix) (together with its subsidiaries, the Company) is an Israeli
  corporation, which operates in one reportable operating business segment
  enterprise IT modernization solutions. The Company develops and markets software
  tools and provides consulting services for efficient modernization of legacy
  systems and cross-platform migration. The Company manages its business in
  various international markets through several entities, including its
  wholly-owned subsidiaries located in: USA, UK, Denmark, Germany, Italy,
  Netherlands, Cyprus, Romania, and Israel. Listed below are details relating
  to BluePhoenixs major subsidiaries:

|                                        |  |                         |     |                          |  |     |  |  |                |  |  | 
|--------------------------------------- |  | ----------------------- | --- | ------------------------ |  | --- |  |  | -------------- |  |  | 
|                                        |  | Shareholding percentage |     | State of
  incorporation | 
|                                        |  |                         |     |                          | 
|Name                                    |  | 2006                    |     | 2005                     |  |     | 
|                                        |  |                         |     |                          |  |     |  | 
|                                        |  | %                       |     |                          | 
|                                        |  |                         |     |                          | 
|Subsidiaries:                           |  |                         |     |                          | 
|BluePhoenix Solutions B.V.
  *          |  |                         | 100 |                          |  | 100 |  |  | Netherlands    | 
|BluePhoenix Solutions
  Nordic Aps *    |  |                         | 100 |                          |  | 100 |  |  | Denmark        | 
|BluePhoenix Solutions UK
  Ltd.         |  |                         | 100 |                          |  | 100 |  |  | United Kingdom | 
|Advanced Systems Europe
  B.V. *        |  |                         | 100 |                          |  | 100 |  |  | Netherlands    | 
|Liraz Systems Ltd.
  (Liraz)          |  |                         | 100 |                          |  | 100 |  |  | Israel         | 
|Mainsoft Corporation
  (Mainsoft)     |  |                         | 58  |                          |  | 58  |  |  | USA            | 
|Outlook & BluePhoenix
  Ltd.            |  |                         | 100 |                          |  | 100 |  |  | Israel         | 
|Liacom Ltd.                             |  |                         | 51  |                          |  | 51  |  |  | Israel         | 
|I-Ter/Informatica &
  Territorio S.p.A. |  |                         | 100 |                          |  | 100 |  |  | Italy          | 

| |                              |                                                                                                                                                             
| | ---------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | * Indirectly
  through Liraz
| |                              |                                                                                                                                                             
| | 2.                           | Principal Shareholder:                                                                                                                                      
| |                              |                                                                                                                                                             
| |                              | Formula
  Systems (1985) Ltd. (Formula) owns 56% of the Companys shares as of
  December 31, 2006.                                                       
| |                              |                                                                                                                                                             
| | 3.                           | Accounting Principles:                                                                                                                                      
| |                              |                                                                                                                                                             
| |                              | The consolidated financial
  statements are prepared in accordance with accounting principles generally
  accepted (GAAP) in the United States of America.

F  7

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting Policies (cont.):

|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-- | ------------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | General
  (cont.):
|   |                   
|   | 4.                 | Functional Currency:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                    | The currency of the
  primary economic environment in which the operations of the Company and most of
  its subsidiaries are conducted is the U.S. dollar (dollar). In addition, a
  substantial portion of the Companys revenues and costs are incurred in
  dollars. Thus, the functional and reporting currency of the Company is
  considered to be the dollar.                                                                                                                                                                                                                                                                                    
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                    | Non monetary transactions
  denominated in currencies other than the dollar are measured and recorded in
  dollar at the exchange rates prevailing at transaction date. Monetary assets
  and liabilities denominated in currencies other than the dollar are translated
  at the exchange rate on the balance sheet date. Exchange gain or losses on
  foreign currency translation are recorded in income.                                                                                                                                                                                                                                              
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                    | For consolidated companies
  whose functional currency is other than the dollar, transactions and balances
  have been translated to dollars under the principles prescribed in Statement
  of Financial Accounting Standards (SFAS) No. 52 of the Financial Accounting
  Standards Board (FASB). Assets and liabilities have been translated at
  period-end exchange rates. Results of operations have been translated at
  appropriately weighted average exchange rates. Differences resulting from
  such translation are presented as a separate component of shareholders
  equity under the caption Accumulated other comprehensive income.
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | 5.                 | Use of Estimates and
  Assumptions in the Preparation of the Financial Statements:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                    | The preparation of
  financial statements in conformity with generally accepted accounting
  principles requires management to make estimates and assumptions that affect the
  reported amounts of assets and liabilities, disclosure of contingent assets
  and liabilities at the dates of the financial statements and the reported
  amounts of revenues and expenses during the reporting periods. Actual results
  could differ from those estimates.                                                                                                                                                                                              

F  8

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Principles
  of Consolidation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | The consolidated financial
  statements include the accounts of BluePhoenix and its subsidiaries in which
  it has a controlling interest, and a certain variable interest entity that
  the Company is required to consolidate pursuant to Financial Accounting
  Standards Board Interpretation No. 46 Consolidation of Variable Interest
  Entities as revised in December 2003 (FIN 46R)  See also Note 2F.
  Acquisition of subsidiaries is accounted for under the purchase method. All
  intercompany balances and transactions have been eliminated upon
  consolidation.                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|C. | Cash and
  Cash Equivalents:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Cash equivalents are
  considered by the Company to be highly-liquid investments, including, inter
  alia, short-term deposits with banks, the maturity of which did not exceed
  three months at the time of deposit and which are not restricted.                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|D. | Provision
  for Doubtful Accounts:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | The provision for doubtful
  accounts was based on specific receivables the collection of which, in the
  opinion of Companys management, is in doubt. Trade receivables are charged
  off in the period in which they are deemed to be uncollectible.                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|E. | Investments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Investments in affiliates
  over which the Company exercises significant influence are accounted for
  under the equity method. Investments in other companies are accounted for
  under the cost method. Investments in marketable securities are classified as
  trading, and unrealized gains or losses there from are reported in the
  statement of operations in accordance with the principles set forth in SFAS
  No. 115 Accounting for Certain Investments in Debt and Equity Securities.
  Investments are periodically reviewed to determine whether an
  other-than-temporary impairment in value has occurred.

F  9

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting
Policies (cont.):

|   |                                                                                                                                                                                                                          | 
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | 
|F. | Property and Equipment, Net:                                                                                                                                                                                             | 
|   |                                                                                                                                                                                                                          | 
|   | Property and
  equipment are stated at cost, net of accumulated depreciation. Depreciation
  is calculated by the straight-line method over their estimated useful lives.
  Annual rates of depreciation are as follows:

| |                                      |                                                                             
| | ------------------------------------ | ----------------------------------------------------------------------------
| |                                      | %                                                                           
| |                                      |                                                                             
| |                                      |                                                                             
| | Computers
  and peripheral equipment | 2033 (mainly 33)                                                           
| | Office
  furniture and equipment     | 615 (mainly 7)                                                             
| | Leasehold
  improvements             | Over the term of the lease or the life of the assets, whichever is
  shorter
| | Motor
  vehicles                     | 15                                                                          

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | 
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|G. | Impairment of Long-Lived Assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | The
  Companys long-lived assets are reviewed for impairment in accordance with
  SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets
  whenever events or changes in circumstances indicate that the carrying amount
  of an asset may not be recoverable. Recoverability of assets to be held and
  used is measured by a comparison of the carrying amount of an asset to the
  future undiscounted cash flows expected to be generated by the assets. If
  such assets are considered to be impaired, the impairment to be recognized is
  measured by the amount by which the carrying amount of the assets exceeds
  their fair value. During the years ended December 31, 2006, 2005 and 2004, no
  impairment losses have been identified.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|H. | Goodwill and other purchased intangible assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
  Assets (SFAS No. 142). SFAS No. 142 requires goodwill to be tested for
  impairment on an annual basis and between annual tests in certain
  circumstances, and written down when impaired, rather than being amortized as
  previous accounting standards required. Furthermore, SFAS No. 142 requires
  purchased intangible assets other than goodwill to be amortized over their
  useful lives unless these lives are determined to be indefinite.                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | SFAS No. 142
  is effective for fiscal years beginning after December 15, 2001. The Company
  adopted SFAS No. 142 effective January 1, 2002. In accordance with SFAS
  No. 142, the Company ceased amortizing goodwill totaling $15.1 million as of
  the beginning of 2002. Based on the impairment tests performed during 2004,
  2005, and 2006, no impairments losses have been identified. There can be no
  assurance that future goodwill impairment tests will not result in a charge
  to earnings.                                                                                                                                                                                                                                                                

F  10

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|I. | Software
  Development Costs:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | Development costs of
  software and products enhancement that are intended for sale, and which were
  incurred after the establishment of technological feasibility of the relevant
  product, are capitalized. Technological
  feasibility is determined when detailed program design is completed and
  verified in accordance with the provisions of SFAS No. 86 Accounting for the
  Cost of Computers Software to Be Sold, Leased or Otherwise Marketed.
  Software development costs incurred before technological feasibility is
  established are charged to the statement of operations as incurred, net of
  participation of the Office of the Chief Scientist of the Israeli Ministry of
  Industry and Trade (the OCS).                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | Amortization of
  capitalized software development costs begins when the product is available
  for general release to customers. Annual amortization is computed by the
  straight-line method, over the remaining useful life of the product, or based
  on the ratio of current gross revenues to current and anticipated future
  gross revenues, whichever is higher. Currently, capitalized software
  development costs are amortized over a period of 5 years. During the year
  ended December 31, 2006, the Company capitalized software development costs
  aggregating $7.5 million (in 2005: $8.0 million, and in 2004: $7.1 million)
  and amortized software development costs aggregating $7.1 million (in 2005:
  $5.1 million, and in 2004: $3.1 million) included in cost of revenues.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | In the Companys
  management estimate, total capitalized costs do not exceed the net realizable
  value of the software product. In the event that unamortized software
  development costs exceed the net realizable value of the product, they would
  be written down to net realizable value.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|J. | Employee
  Share Options:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | Effective January 1, 2006,
  the Company adopted the provisions of Statement of Financial Accounting
  Standard No. 123 (revised 2004) (FAS 123R), Share-Based Payment, and
  Staff Accounting Bulletin No. 107 (SAB 107), which was issued in March 2005
  by the SEC. FAS 123R addresses the accounting for share-based payment
  transactions in which the Company obtains employee services in exchange for
  equity instruments of the Company. This statement requires that employee
  equity awards be accounted for using the grant-date fair value method. SAB
  107 provides supplemental implementation guidance on FAS 123R, including
  guidance on valuation methods, classification of compensation expense, income
  statement effects, disclosures and other issues.              

F  11

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|J. | Employee
  Share Options (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | FAS 123R supersedes the Companys
  previous accounting for its employee stock option plans using the intrinsic
  value-based method of accounting prescribed under Accounting Principles Board
  Opinion No. 25 (APB 25) and related interpretations. The Company elected to
  adopt the modified prospective transition method permitted by FAS 123R. Under
  such transition method, the new standard has been implemented as from January
  1, 2006, with no restatement of prior periods to reflect the fair value
  method of expensing share-based compensation.                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | The Company has expensed
  compensation costs, applying the accelerated vesting method, based on the
  grant-date fair value estimated in accordance with the original provisions of
  FAS 123, and previously presented in the pro forma footnote disclosures.
  Results for prior periods have not been restated as explained above. For the
  year ended December 31, 2006, the Company recorded stock-based compensation
  costs in the amount of $40 thousand. On December 31, 2006, the total
  unrecognized compensation cost on employee stock options amounted to $150
  thousand, and is expected to be recognized over a weighted average period of
  3 years.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | The Company issues stock
  options to its employees and directors and provides the right to purchase
  stock pursuant to approved stock option and employee stock purchase programs.
  Prior to the adoption of FAS 123R, the Company elected to follow Accounting
  Principles Board Opinion No. 25, Accounting for Stock Options Issued to
  Employees and related interpretations (collectively APB No. 25), in
  accounting for its stock option plans. Under APB No. 25, when the exercise
  price of an employee stock option is less than the market price of the
  underlying stock on the date of grant, compensation expense is recognized.                

F  12

---

---



BLUEPHOENIX SOLUTIONS LTD.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting
Policies (cont.):

|   |                                                                                                                                                                                                                                                            
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|J. | Employee Share Options (cont.):                                                                                                                                                                                                                            
|  
|   | The
  following table illustrates the effect on net income and earnings per share,
  assuming the Company had applied the fair value recognition provisions of FAS
  123 (as amended by FAS 148) to its stock-based employee compensation in prior
  years:

|                                                                                                                                                |  |                                          |         |      |   |       |  
|----------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ------- | ---- | - | ----- | -
|                                                                                                                                                |  | Year ended December 31,                  |        
|                                                                                                                                                |  |                                          |        
|                                                                                                                                                |  | 2005                                     |         | 2004 |  
|                                                                                                                                                |  |                                          |         |      |  
|                                                                                                                                                |  | (in thousands, 
  except per share data) |        
|                                                                                                                                                |  |                                          |        
|Net income as reported                                                                                                                          |  | $                                        | 1,789   |      | $ | 2,846 |  
|                                                                                                                                                |  |                                          |         |      |   |       |  
|Deduct: Total stock-based employee
  compensation expense determined under fair value based method for all awards,
  net of related tax effects |  |                                          | *(1,851 | )    |   | (624  | )
|                                                                                                                                                |  |                                          |         |      |   |       |  
|Pro forma net income                                                                                                                            |  | $                                        | (62     | )    | $ | 2,222 |  
|                                                                                                                                                |  |                                          |         |      |   |       |  
|Earnings per share:                                                                                                                             |  |                                          |         |      |   |       |  
|                                                                                                                                                |  |                                          |         |      |   |       |  
|Basic - as reported                                                                                                                             |  | $                                        | 0.13    |      | $ | 0.21  |  
|                                                                                                                                                |  |                                          |         |      |   |       |  
|Basic - pro forma                                                                                                                               |  | $                                        | (0.00   | )    | $ | 0.16  |  
|                                                                                                                                                |  |                                          |         |      |   |       |  
|Diluted - as reported                                                                                                                           |  | $                                        | 0.13    |      | $ | 0.21  |  
|                                                                                                                                                |  |                                          |         |      |   |       |  
|Diluted - pro forma                                                                                                                             |  | $                                        | (0.00   | )    | $ | 0.16  |  
|                                                                                                                                                |  |                                          |         |      |   |       |  

|   |                                                                                                                                                                                                                                                                                                                                                                              |                                                                                
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------
|   | *                                                                                                                                                                                                                                                                                                                                                                            | Mainly due
  to an acceleration of unvested stock options (see also Note 11B1).
|   |                                                                                                                                                                                                                                                                                                                                                                              |                                                                                
|K. | Revenue Recognition:                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                              |                                                                                
|   | Revenues
  derived from direct software license agreements are recognized in accordance
  with Statement of Position (SOP) 97-2 Software Revenue Recognition (as
  amended by SOP 98-4 and SOP 98-9), upon delivery of the software, when
  collection is probable, the license fee is otherwise fixed or determinable
  and persuasive evidence of an arrangement exists.
|   |                                                                                                                                                                                                                                                                                                                                                                              |                                                                                
|   | The
  arrangements that include multiple elements are usually arrangements where
  the Company sells software products and Post Contract Support (PCS).                                                                                                                                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                              |                                                                                
|   | In addition,
  there are certain arrangements where the Company sells software and
  consulting services. Consulting service fees are based on time invested.                                                                                                                                                                                                               

F  13

---

---



BLUEPHOENIX SOLUTIONS LTD.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting
Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|K. | Revenue Recognition (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|  
|   | For these
  multiple elements, SOP 97-2 requires that the fair value of each component in
  a multiple element arrangement will be determined based on the vendors
  specific objective evidence (VSOE) for that element, and revenue is allocated
  to each component based on its fair value. SOP 98-9 requires that revenue be
  recognized under the residual method when VSOE does not exist for all the
  delivered elements, VSOE of fair value exists for all undelivered elements,
  and all other SOP 97-2 criteria are met. Under the residual method, any
  discount in the arrangement is allocated to the delivered elements. The
  specific objective evidence for the PCS is established by the price charged
  on separate PCS renewal contracts. The VSOE for the consulting services is
  established by the price charged on other time based consulting service
  contracts where no sale of other elements is involved, considering the
  territory where the service is performed, the size of the customer, the
  quantity of the purchased services, the professional expertise of the
  consultants, etc. The revenue associated with the delivered elements is
  recognized using the residual method discussed above.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The Company
  recognizes revenues from consulting fees with respect to projects billed on a
  time and material basis, based on the number of hours performed.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In some of
  the agreements with the Companys customers, the customers have the right to
  receive unspecified upgrades on an if-and-when available basis (the Company
  does not provide specific upgrades). These upgrades are considered
  Post-Contract Support (PCS). Revenue allocated to the PCS is recognized
  ratably over the term of the PCS.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | When a
  project involves significant production, modification, or customization of
  software, and for other fixed fee contracts, revenue is generally recognized
  according to the percentage of completion method, in accordance with the
  provisions of SOP 81-1 Accounting for Performance of Construction-Type
  Contracts. Under this method, estimated revenue is generally accrued based
  on costs incurred to date, as a percentage of total updated estimated costs.
  Contracts with extended payment terms are initially recorded in present value
  in accordance with APB 21 Interest on Receivables and Payables.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The Company
  recognizes contract losses, if any, in the period in which they first become
  evident.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | Some of the
  Companys contracts include client acceptance clauses. In these contracts,
  the Company follows the guidance of TPA 5100.67 and SAB 104. In determining
  whether revenue can be recognized, when an acceptance clause exists, the
  Company considers its history with similar arrangements, the customers
  involvement in the progress, and the existence of other service providers and
  the payments terms. There are no rights of return, price protection or
  similar contingencies in the Companys contracts.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | On December
  31, 2006 approximately $13.7 million (on December 31, 2005: $7.8 million) of
  the accounts receivable balance was unbilled due to the customers payment
  terms.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

F  14

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting
Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|K. | Revenue Recognition (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | Management
  believes that the Companys revenue recognition policies are in accordance
  with the Securities and Exchange Commission Staff Accounting Bulletin
  No. 101 and SAB 104, Revenue Recognition in Financial Statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | Tax
  collected from customers and remitted to governmental authorities (including
  VAT) are presented in income statement on a net basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|L. | Advertising Costs:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | The Company
  expenses advertising costs as incurred. Advertising costs for the years ended
  December 31, 2006, 2005, and 2004 were $125, $39, and $25 thousand,
  respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|M. | Gain on Realization of Shareholdings:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | Gain on
  realization of shareholdings includes the results of realization of the
  Companys shareholdings in investees arising either from the sale of such
  shareholdings or from issuance of stock by the investees to third parties,
  which is recognized in accordance with the provisions of Staff Accounting
  Bulletin (SAB) No. 51 of the Securities and Exchange Commission. The Company
  includes such results in statement of operations, provided that the
  conditions stipulated in SAB 51 for such recognition have been met.                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|N. | Deferred Income Taxes:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | The Company
  accounts for income taxes in accordance with Statement of Financial
  Accounting Standards No. 109, Accounting for Income Taxes (SFAS No. 109).
  This Statement prescribes the use of the liability method, whereby deferred
  tax asset and liability account balances are determined based on differences
  between financial reporting and the tax bases of assets and liabilities and
  are measured using the enacted tax rates and laws that will be in effect when
  the differences are expected to reverse. The Company provides a valuation
  allowance, when its more likely than not that deferred tax assets will not
  be realized in the foreseeable future.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|O. | Earnings Per Share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | Earnings per
  share (EPS) were computed in accordance with the provisions of SFAS No. 128
  of the FASB (SFAS No. 128). SFAS No. 128 requires the presentation of both
  basic and diluted EPS.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | Basic net
  earnings per share are computed based on the weighted average number of ordinary
  shares outstanding during each year. Diluted earnings per share is computed
  based on the weighted average number of ordinary shares outstanding during
  each year, plus dilutive potential ordinary shares considered outstanding
  during the year.                                                                                                                                                                                                                                                                                                                                         

F  15

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 1  Summary of Significant Accounting Policies (cont.):
|                                                             |                                                                                                                                                                                                                                                                                               
|P.                                                           | Financial Instruments:                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                                                                                                       
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             | 1.                                                                                                                                                                                                                                                                                             | Management of credit risks:                                                                                                                                                                                                                                                                                           
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             |                                                                                                                                                                                                                                                                                                | Financial
  instruments that have the potential to expose the Company to credit risks are
  mainly cash and cash equivalents, marketable securities, bank deposit
  accounts, credit facilities, trade payables, and trade receivables.                                                                               
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             |                                                                                                                                                                                                                                                                                                | The Company
  holds cash and cash equivalents, marketable securities, and deposit accounts
  at large banks in Israel, the United States, and Europe, thereby
  substantially reducing the risk of loss.                                                                                                              
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             |                                                                                                                                                                                                                                                                                                | With respect
  to trade receivables, the risk is limited due to the nature and size of the
  entities that constitute the Companys customer base. The Company assesses
  the financial position of its customers prior to the engagement with them,
  and has not encountered material credit difficulties therewith.
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             | 2.                                                                                                                                                                                                                                                                                             | Fair value of financial instruments:                                                                                                                                                                                                                                                                                  
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             |                                                                                                                                                                                                                                                                                                | The
  financial instruments of the Company consist mainly of cash and cash
  equivalents, marketable securities, bank deposit accounts, credit facilities,
  trade payables, loans and credit from banks and trade receivables.                                                                                       
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             |                                                                                                                                                                                                                                                                                                | The
  convertible debentures are valued using the discounted cash flows model based
  on the LIBOR interest rate. Embedded derivatives in connection with the
  convertible debentures are measured at fair value using the Black-Scholes
  pricing model.                                                            
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             |                                                                                                                                                                                                                                                                                                | The Market
  value of Series A convertible notes is $13.5million as of December 31, 2006.
  The book value as of that date was $12.2 million.                                                                                                                                                                         
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             |                                                                                                                                                                                                                                                                                                | In view of
  their nature, the fair value of the financial instruments included in the
  Companys working capital is usually identical or close to their carrying
  value.                                                                                                                                           
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|Q.                                                           | Comprehensive Income:                                                                                                                                                                                                                                                                         
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             | The Company
  adopted Statement of Financial Accounting Standards No.130, Reporting
  Comprehensive Income (SFAS 130). SFAS 130 establishes standards for
  reporting and presentation of comprehensive income and its components in a
  full set of general purpose financial statements.
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             | Comprehensive
  income presented in shareholders equity includes, in addition to net income,
  translation gains and losses of non-dollar currency financial statements of
  subsidiaries.                                                                                                   
|                                                             |                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                       
|                                                             | The
  comprehensive income for the years ended December 31, 2004, 2005 and 2006
  were $2,691, $1,883 and $4,672 thousand, respectively.                                                                                                                                                      

F  16

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|------------------------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 1  Summary of Significant Accounting Policies (cont.):
|                                                            
|R.                                                           | Derivative Instruments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                             | The Company has adopted Statement of Financial Accounting Standards
  SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities.
  Under the provisions of SFAS 133, all derivatives are recognized on the
  balance sheet at their fair value. Changes in fair value are recognized
  periodically in earnings or accumulated other comprehensive income within
  shareholders equity, depending on the intended use of the derivative and
  whether the derivative has been designated by management as a hedging
  instrument. Changes in fair value of derivative instruments not designated as
  hedging instruments are recognized in earnings in the current period.                                                                                                                        
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                             | The Company uses foreign currency options, forward exchange contracts
  and forward interest contracts to assist in managing financial risks. The
  Company does not use derivative financial instruments for speculative
  purposes. These instruments are recognized at fair value, with all changes in
  fair value recorded in current period earnings, as these transactions have
  not been designated by management as hedging instruments under SFAS 133. The
  net gain recognized in earnings during 2006, representing the derivative
  instruments was $275 thousand (in 2005: $200 thousands). As of December 31,
  2006 the Company is obligated to purchase  5 million at an average exchange
  rate of 1.285 per dollar and to sell 8 million at an average exchange rate
  of 1.2948 per dollar).
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                             | In addition, the Company entered into LIBOR interest forward
  transaction for $10.8 million at an average interest rate of 5.08%.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|S.                                                           | Royalty-Bearing Grants:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                             | Royalty-bearing grants from the Government of Israel and other
  governmental institutions for funding approved research and development
  projects, are recognized at the time the Company is entitled to such grants.
  Such grants are included as a deduction of software development costs. The
  Company is committed to pay royalties related to grants from the Government
  of Israel on sales with regard to the funded products of approximately 3% of
  the generated revenues from such products. These royalties are recognized as
  incurred as costs of revenues.                                                                                                                                                                                                                                     
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|T.                                                           | Treasury Shares:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                             | Treasury shares are presented as a reduction of shareholders equity,
  at their cost to the Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|U.                                                           | Recently Issued Accounting Pronouncements:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                             | In February
  2006, the FASB issued FAS 155, Accounting for Certain Hybrid Financial
  Instruments, an Amendment of FASB Statements No. 133 and 140. This
  statement permits fair value measurement for any hybrid financial instrument
  that contains an embedded derivative that otherwise would require
  bifurcation. This statement is effective for all financial instruments
  acquired or issued after the beginning of an entitys first fiscal year that
  begins after September 15, 2006. The Company is currently
  evaluating the impact of this statement, if any, on its consolidated
  financial statements.                                                                                                                                                                                     

F  17

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|------------------------------------------------------------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 1  Summary of Significant Accounting Policies (cont.):
|                                                            
|U.                                                           | Recently Issued Accounting Pronouncements (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                             | In July
  2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes-an
  interpretation of FAS 109. This financial interpretation clarifies the
  accounting for uncertainty in income taxes, and prescribes a recognition
  threshold and measurement attributes for the financial statement recognition
  and measurement of a tax position taken or expected to be taken in a tax
  return. FIN 48 also provides guidance on various related matters such as
  derecognition, interest and penalties and disclosure. As applicable to the
  Company, the interpretation prescribed by FIN 48 will be effective commencing
  January 1, 2007. The Company is currently evaluating the impact that the
  adoption of FIN 48 would have on its consolidated financial statements.
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                             | In September
  2006, the FASB issued FAS 157, Fair Value Measurements. This standard
  establishes a framework for measuring fair value and expands related
  disclosure requirements; however, it does not require any new fair value
  measurement. As applicable to the Company, this statement will be effective
  as of the year beginning January 1, 2008. The Company is currently
  evaluating the impact that the adoption of FAS 157 would have on its
  consolidated financial statements.                                                                                                                                                                                                                                                                                           
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                             | In September
  2006, the SEC issued Staff Accounting Bulletin (SAB) 108, which expresses the
  Staffs views regarding the process of quantifying financial statement
  misstatements. The bulletin was effective as of the year beginning
  January 1, 2006. The implementation of this bulletin had no impact on
  the Companys consolidated financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                             | In February
  2007, the FASB issued FAS 159, The Fair Value Option for Financial Assets
  and Financial Liabilities. This standard permits entities to choose to
  measure many financial assets and financial liabilities at fair value.
  Unrealized gains and losses on items for which the fair value option has been
  elected are reported in earnings. As applicable to the Company, this
  statement will be effective as of the year beginning January 1, 2008.
  The Company is currently evaluating the impact that the adoption of FAS 159
  would have on its consolidated financial statements.                                                                                                                                                                                   
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                             | In September
  2006, the FASB issued SFAS No. 158, Employers Accounting for Defined
  Benefit Pension and Other Postretirement PlansAn Amendment of FASB
  No. 87, 88, 106 and 132(R) (SFAS 158). SFAS 158 requires
  that the funded status of defined benefit postretirement plans be recognized
  on the companys balance sheet, and changes in the funded status be reflected
  in comprehensive income, effective fiscal years ending after
  December 15, 2006. The adoption of this statement did not have an
  impact on the consolidated financial statements.                                                                                                                                                                                                                    

F  18

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|------------------------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 1  Summary of Significant Accounting Policies (cont.):
|                                                            
|U.                                                           | Recently Issued Accounting Pronouncements (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                             | In December 2006, the FASB posted FASB
  Staff Position, or FSP, 00-19-2, Accounting for Registration Payment
  Arrangements. This FSP specifies that the contingent obligation to make
  future payments or otherwise transfer consideration under a registration
  payment arrangement, whether issued as a separate agreement or included as a
  provision of a financial instrument or other agreement should be separately
  recognized and measured in accordance with FAS No. 5, Accounting for
  Contingencies. This FSP further clarifies that a financial instrument
  subject to a registration payment arrangement should be accounted for in
  accordance with other applicable GAAP without regard to the contingent
  obligation to transfer consideration pursuant to the registration payment
  arrangement. This FSP is effective immediately for registration payment
  arrangements and financial instruments subject to those arrangements that
  were entered into or modified subsequent to December 15, 2006. For
  registration payment arrangements and financial instruments subject to those
  arrangements that were entered into prior to December 15, 2006, the FSP
  is effective for fiscal years beginning after December 15, 2006, and
  interim periods within those fiscal years. The company will adopt FSP 00-19-2
  beginning January 1, 2007 and it is currently evaluating the potential
  impact the adoption of this pronouncement will have on its consolidated
  financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                             | In November
  2006, the FASB ratified EITF Issue No. 06-7, Issuers Accounting for a
  Previously Bifurcated Conversion Option in a Convertible Debt Instrument When
  the Conversion Option No Longer Meets the Bifurcation Criteria in FASB
  Statement No. 133, Accounting for Derivative Instruments and Hedging
  Activities (EITF 06-7). At the time of issuance, an embedded conversion
  option in a convertible debt instrument may be required to be bifurcated from
  the debt instrument and accounted for separately by the issuer as a
  derivative under FAS 133, based on the application of EITF 00-19. Subsequent
  to the issuance of the convertible debt, facts may change and cause the
  embedded conversion option to no longer meet the conditions for separate
  accounting as a derivative instrument, such as when the bifurcated instrument
  meets the conditions of Issue 00-19 to be classified in stockholders equity.
  Under EITF 06-7, when an embedded conversion option previously accounted for
  as a derivative under FAS 133 no longer meets the bifurcation criteria under
  that standard, an issuer shall disclose a description of the principal
  changes causing the embedded conversion option to no longer require
  bifurcation under FAS 133 and the amount of the liability for the conversion
  option reclassified to stockholders equity. In addition, under the EITF, for
  conversion of option for which the carrying amount has previously been
  reclassified to shareholders equity, the issuer should recognize any
  unamortized discount remaining at the date of conversion immediately as
  interest expense. EITF 06-7 should be applied to all previously bifurcated
  conversion options in convertible debt instruments that no longer meet the
  bifurcation criteria in FAS 133 in interim or annual periods beginning after
  December 15, 2006, regardless of whether the debt instrument was entered into
  prior or subsequent to the effective date of EITF 06-7. Earlier application
  of EITF 06-7 is permitted in periods for which financial statements have not
  yet been issued. The Company is currently evaluating the impact of this
  guidance on its consolidated financial statements.

F  19

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions:

In order to enhance the Companys solutions and
services portfolio, the Company have been pursuing a strategy of adding new
technologies to its suite of automated modernization tools. The Company
implements this strategy via internal development of new software tools and
through acquisitions and investments. Accordingly, the Company invests in
businesses that develop software tools that are complementary to its existing
portfolio.

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | CodeStream
  Software Ltd.:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In December 2006, the Company acquired from a
company incorporated in the United Kingdom, CodeStream Software Ltd., certain
business activities in the field of modernization of legacy databases,
particularly IDMS and other mainframe platforms. Pursuant to the purchase
agreement, the Company hired 18 persons previously employed by CodeStream and
assumed all the obligations in respect of the purchased activities. In
consideration thereof the Company paid CodeStream £5.2 million (approximately $10.2 million).                                                                                                                                                                                                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In addition, the Company undertook to issue to
CodeStream a convertible debenture in a principal amount of £2.9 million (approximately $5.7 million), if, (i) not later than
December 14, 2008, the Company receive purchase orders from a key customer of
CodeStream, in an aggregate amount of not less than £2.2 million (approximately $4.3 million), and (ii) such purchase
orders are collectible under the purchase orders not later than December 14,
2009. The debenture shall be issued upon the fulfillment of the
aforementioned conditions and shall be due two years after the date of
issuance. The debenture shall bear interest at a rate of LIBOR plus 1.5%
calculated on a quarterly basis. Interest shall be calculated on the
principal amount of the debenture beginning on December 14, 2006.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In addition, the Company undertook to issue to
CodeStream a second convertible debenture in a principal amount of £500,000 (approximately $982 thousand), if (i) not later
than December
14, 2010, the Company receives an additional purchase orders from the same
key customer of CodeStream, in an aggregate amount of not less than £800,000 (approximately $1.6 million), and (ii) such
purchase orders
are collectible not later than 36 months after the first debenture was
issued. The debenture shall be due two years after the date of issuance and
shell bear interest at a rate of LIBOR plus 1.5% calculated on a quarterly
basis. Interest will accrue on the principal amount of the debenture
beginning on the date of issuance of the first debenture.                                           

F  20

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | CodeStream
  Software Ltd. (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The debentures will be convertible into BluePhoenixs
  ordinary shares at a conversion rate of $6.00 per ordinary share, subject to
  adjustment for stock dividends, stock splits, recapitalization and other
  similar events. At the request of the holders of the debentures, given six
  months in advance, the Company will repay the amount of the debentures prior
  to their respective due dates. At the request of the holders of a majority of
  the shares underlying each of the debentures, given within 10 business days
  after issuance of the debenture, the Company will file a registration
  statement under the Securities Act 1933, referred to as the Securities Act,
  for an offering of the shares underlying the debentures. In addition, if the
  Company otherwise proposes to register its ordinary shares under the Securities
  Act, the holders of the debentures may request that the Company register
  their underlying shares as well, subject to certain limitations. In the event
  that the repayment date of a debenture occurs earlier than 6 months after the
  registration statement becomes effective, then the repayment date of the
  debenture shall be postponed until a date which is 6 months after the
  effective date of the registration statement. In the event that holders of
  50% or more of the principal amount of a debenture request repayment of the
  debenture prior to its due date, the Company shall be released from its
  undertakings with respect to the registration described above.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | Since CodeStreams activity constitutes a
  business in accordance with EITF 98-3 Determining Whether a Non-monetary
  Transaction Involves Receipt of Productive Assets of a Business, the
  acquisition was accounted under the guidelines of SFAS 141 Business
  Combinations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | Accordingly, the consideration of the acquisition
  was attributed to net assets acquired and liabilities assumed based on their
  fair value. Upon a purchase price allocation performed by an independent
  appraisal, an amount of $4.6 million was allocated to CodeStreams core
  technology to be amortized over 5  years period, and an amount of $0.5
  million was allocated to estimated
  fair value of the customer related intangible assets, which is being
  amortized over its estimated useful life  currently 5 years, and an amount
  of $5.8 million was allocated to goodwill. The future contingent consideration,
  if established, will be recorded as goodwill.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

F  21

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions (cont.):

|   |                                                                                                                        
|-- | -----------------------------------------------------------------------------------------------------------------------
|A. | CodeStream
  Software Ltd. (cont.):                                                                                    
|   |                                                                                                                        
|   | The following table summarizes the fair values of
  assets acquired and liabilities assumed as of the date of purchase:

|                                                |  |                |        | 
|----------------------------------------------- |  | -------------- | ------ | 
|                                                |  | (in thousands) |       
|                                                |  |                |       
|                                                |  |                |       
|Current assets                                  |  | $              | 44     | 
|Property and equipment,
  net                   |  |                | 285    | 
|                                                |  |                |        | 
|Goodwill                                        |  |                | 5,778  | 
|Technology                                      |  |                | 4,600  | 
|Customer related
  intangible asset             |  |                | 470    | 
|                                                |  |                |        | 
|                                               
|Total tangible and
  intangible assets acquired |  |                | 11,177 | 
|                                                |  |                |        | 
|Current liabilities                             |  |                | 304    | 
|                                                |  |                |        | 
|Total liabilities assumed                       |  |                | 304    | 
|                                                |  |                |        | 
|Net assets acquired                             |  | $              | 10,873 | 
|                                                |  |                |        | 

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | BluePhoenix
  Solutions Srl (previously known as AlphaTech (2000) Srl):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | In December 2002, the
  Company purchased a 65% controlling interest in AlphaTech (2000) Srl.
  (AlphaTech) from Intercomp for an aggregate consideration of $100 thousand.
  In February 2005, the Company entered into an agreement with the other
  shareholder of AlphaTech to purchase for $250 thousand its entire holdings in
  AlphaTech, which as of such date was equal to 35% of AlphaTechs outstanding
  share capital. In 2005, AlphaTech changed its name to BluePhoenix Solutions
  Srl. BluePhoenix Solutions Srl., a company incorporated in Romania, serves as
  the Companys offshore delivery center in Romania.                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|C. | CePost:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | In January 2004, the
  Company purchased the entire outstanding share capital of CePost Ltd., an
  Israeli Company that develops and markets software solutions for electronic
  document mining, management, and presentment. Pursuant to the purchase
  agreement, the Company paid $172.5 thousand to the shareholders of CePost and
  issued to them 31,496 of BluePhoenixs ordinary shares, valued at the fair
  value of $200 thousand. In addition, the Company undertook to pay to the
  sellers royalties from CePosts revenues in an amount of up to $1.5 million.
  At its option, the Company may pay the contingent consideration in the form
  of BluePhoenixs ordinary shares.

F  22

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |                                                                                                                                                                                                                    
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|C. | CePost
  (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |                                                                                                                                                                                                                    
|   | At acquisition, the
  Company accounted for the contingent purchase consideration at the minimum
  level of $120 thousand, in accordance with SFAS No. 141 and will be accounted
  as an additional cost of the acquired entity. In accordance with the purchase
  agreement, the Company paid the sellers in 2005 and 2006 advances in an
  aggregate amount of $45 thousand on account of the contingent consideration.
  In accordance with CePost results, there was no need to update the contingent
  purchase consideration since acquisition.                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   | The fair value assigned to
  CePosts technologies was $553 thousand and it is being amortized over a
  5-year period.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|D. | Outlook:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   | Effective as of January
  2004, the Company acquired from an Israeli Company, Outlook Systems Ltd.
  through a new wholly-owned subsidiary, Outlook & BluePhoenix Ltd.,
  Outlook Systems entire business activities in Israel in the field of
  software development services. Pursuant to the purchase agreement, the
  Company hired 31 employees previously employed by Outlook Systems and assumed
  all the obligations in respect of the purchased activity. Under the purchase
  agreement, as amended in 2006, the Company paid to Outlook Systems an
  aggregate amount of approximately $1.3 million.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   | In accordance with the
  amendment to the purchase agreement, a guarantee provided by the company to
  secure bank loans of Outlook Systems was cancelled. In addition, Outlook
  Systems received 138,591 of BluePhoenixs ordinary shares. As part of the
  amendment, the Company undertook to pay Outlook Systems consideration to be
  calculated based on Outlook & BluePhoenix Ltd.s annual earnings before
  interest and taxes, referred to as EBIT, during the three-year period
  commencing on July 1, 2005, as follows:                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | For an amount of up to
  $300,000 of the annual EBIT in each year within the three-year EBIT period,
  the Company will pay Outlook Systems consideration equal to 10% of the EBIT;                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | For an amount of annual
  EBIT in a fiscal year within the three-year EBIT period in excess of
  $300,000, the Company will pay Outlook Systems an additional consideration
  equal to 15% of the excessive amount.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |                                                                                                                                                                                                                    
|   | The value assigned to the
  customer related intangible asset amounted to $425 thousand, and it is being
  amortized over its estimated useful life-currently 6 years.                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |                                                                                                                                                                                                                    
|   | During 2005, the Company
  recorded an amount of $1.3 million as an additional payment which was
  allocated to goodwill based upon a purchase price allocation performed by the
  Company at acquisition date. Based on the EBIT during the 18 months
  commencing on July 1, 2005, the accrued contingent consideration is $35
  thousand which was recorded as goodwill.                                                                                                                                                                                                                                      

F  23

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|E. | Intercomp:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | In
  1998, the Company invested in Intercomp Ltd., (Intercomp), which has
  developed a set of automated analysis and reengineering tools for legacy
  COBOL applications. During 2002 and 2003, Intercomp focused its efforts on
  the development of software tools that comprise a part of the Companys
  LogicMiner tool.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | In 2004, the Company
  exercised an option granted to the company, to purchase from a former
  shareholder of Intercomp all of his holdings in Intercomp, consisting of
  18.5% of the outstanding share capital of Intercomp. In consideration, the
  Company issued to the selling shareholder warrants to purchase BluePhoenix
  ordinary shares which expired without being exercised. As part of the
  transaction with the former shareholder, certain shareholders of Intercomp,
  holding 2.1% of Intercomps outstanding share capital, transferred their
  holdings in Intercomp to the Company. In addition, the remaining shareholders
  of Intercomp comprised of several funds acting through their general partner,
  Israel Infinity Venture Capital Partners Ltd., referred to as Infinity,
  converted certain outstanding loans owed to it by Intercomp into 7,236 shares
  of Intercomp at a price of $162.70 per share. Following these transactions,
  the Companys holdings in Intercomp increased from 49% to approximately 62%.
  Since the end of the first quarter of 2004, the Company consolidates the
  results of operations of Intercomp.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | Concurrently with the
  grant by the former shareholder of the option to purchase from him his
  holdings in Intercomp, Intercomp granted nonexclusive rights to a distributor
  partially owned by the former shareholder, to further develop and distribute
  Intercomps products.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | In April 2004, Infinity
  granted the Company a call option to purchase its entire holdings in
  Intercomp. The option expired without being exercised by the Company. As a
  result, Infinity exercised a put option granted to it, to cause the Company
  to purchase Infinitys entire holdings in Intercomp. In consideration for
  Intercomps shares, the company issued to Infinity 100,719 BluePhoenix
  ordinary shares in the first quarter of 2007. As previously agreed with
  Infinity, the Company filed a registration statement under the Securities Act
  with respect to the ordinary shares issued to Infinity. Subsequent to the
  exercise of the option by Infinity, the Company currently wholly owns
  Intercomp.                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | In the first quarter of
  2006, FIMI, a creditor of Intercomp, has completed exercising a put option to
  sell to the Company convertible promissory notes issued by Intercomp, in an
  aggregate principal amount of $3.5 million. The put option was originally
  granted to FIMI in January 2001. As consideration thereof, the Company paid
  FIMI an aggregate amount of $4.48 million including interest accrued, which
  equals the book value of the promissory notes, and issued to FIMI warrants to
  purchase 210,000 BluePhoenix ordinary shares at an exercise price of $4.00
  per share. No gain or loss was recorded at the repayment date. In the first
  quarter of 2007 FIMI exercised all its warrants.                                                                                                                                                                                                                                                                                                                                                                                                                                               

F  24

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|F. | M.S.I. MultiConn Solutions and MultiConn Technologies:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In 1999, the Company
  acquired 51% of the outstanding share capital of M.S.I. MultiConn Solutions
  International (1995) Ltd. (M.S.I. MultiConn). M.S.I. MultiConns results of
  operations were consolidated in the Companys financial statements beginning
  with the third quarter of 1999. In 2000, the Company increased its holding in
  M.S.I. MultiConn to 60%. Effective as of January 2004, the other shareholders
  of M.S.I. MultiConn transferred their entire holdings in M.S.I MultiConn to
  the Company. Following this transaction, the Company assumed control over the
  daily management of M.S.I. MultiConn. The Company currently wholly owns the
  entire share capital of M.S.I MultiConn and finances its activities.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In 2000, the Company
  established together with the other shareholders of M.S.I. MultiConn a
  company named MultiConn Technologies Ltd. and initially owned 19% of its
  share capital.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | MultiConn Technologies
  develops and markets BluePhoenix SOA - Ready Enablement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In 2002, the Company
  increased its holdings in MultiConn Technologies to 60%. Since the first
  quarter of 2003, the Company has recorded the investment under the equity
  method and did not consolidate the results of operations of MultiConn
  Technologies, due to lack of control.                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | Following a transaction
  entered into between the Company and the other shareholders of MultiConn
  Technologies in 2004, the other shareholders of MultiConn Technologies
  increased their holdings in MultiConn Technologies to 58.2% in the aggregate,
  through the issuance of shares by MultiConn Technologies. As a result, the
  Company currently holds approximately 40% of the outstanding share capital of
  MultiConn Technologies. The Company has an option to increase its holdings in
  MultiConn Technologies to 60% for an exercise price of $50 thousand.                                                                                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In 2004, the Company
  included in losses of affiliated companies 100% of the losses of MultiConn
  Technologies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In 2004, the Company did
  not recognize any gain in the above-mentioned transaction.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The Company is deemed the
  primary beneficiary of MultiConn Technologies in accordance with FIN 46R
  Consolidated of Variable Interest Entities, and accordingly consolidated
  MultiConn Technologies in its financial statements commencing December 31,
  2004 and thereafter. The adoption of FIN 46R has no impact on the Companys
  net income since it has already recorded 100% of MultiConn Technologies
  losses in 2004 under the equity method.                                                                                                                                                                                                                                                                                    

F  25

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|G. | I-Ter/Informatica
  & Territorio S.p.A.:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | In the second quarter of
  2005, the Company entered into an agreement to purchase the entire
  outstanding share capital of I-Ter/Informatica & Territorio S.p.A.
  (I-Ter). Pursuant to the purchase agreement, the Company paid to the
  selling shareholders of I-Ter $1.4 million. Under the terms of the
  transaction, the Company agreed to pay the selling shareholders an additional
  consideration of up to $720 thousand based on I-Ters cumulative earnings
  before interest and taxes, referred to as EBIT. As agreed, if the EBIT in any
  calendar year during the three-year period commencing on January 1, 2005, is
  equal to or greater than $6 thousand, the Company will pay the selling shareholders an additional
  $240 thousand with respect to each such year. In 2006 the
  Company paid $240 thousand since I-Ter met the criteria in fiscal 2005. Since
  the EBIT in 2006 exceeded the minimal level, the Company recorded a
  contingent consideration in the amount of $240 thousand as goodwill.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | In addition, the Company agreed to pay to the
  selling shareholders, at such date that is 15 business days following the
  date on which the EBIT report for the year ended on December 31, 2007 is
  final, an additional consideration equal to seven times the yearly average
  EBIT in the three-year period commencing on January 1, 2005, less the amounts
  already paid to the selling shareholders for the purchased shares. In addition,
  in the event that the yearly average EBIT in the three-year period commencing
  on January 1, 2005 is greater than $600 thousand, the Company shall pay the
  selling shareholders an amount equal to nine times of the difference between
  the yearly average EBIT in the three-year period commencing on January 1,
  2005 and $600 thousand.                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | The consideration for the
  acquisition was attributed to net assets on the basis of fair value of assets
  acquired and liabilities assumed. Based upon a purchase price allocation
  performed by the Company, an amount of $498 thousand was allocated to the
  estimated fair value of the customer related intangible assets, which is
  being amortized over its estimated useful life  currently 3 years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | An amount of $1,158
  thousand of the purchase price was allocated to I-Ters core technology and
  is being amortized over 5-year period.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | During the
  years 2005 and 2006 the Company accounted for the contingent purchase
  consideration in a total amount of $480 thousand as goodwill in respect for
  those years, based upon a purchase price allocation performed by the Company
  at the acquisition date, in accordance with SFAS No. 141.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

F  26

---

---



BLUEPHOENIX SOLUTIONS LTD.NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions (cont.):

|   |                                                                                                                                                                      
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
|G. | I-Ter/Informatica
  & Territorio S.p.A. (cont.):                                                                                                                     
|   |                                                                                                                                                                      
|   | The following table
  summarizes the fair values of the assets acquired and liabilities assumed
  with reference to I-Ters balance sheet as of the date of purchase.

| |                                               |  |                |       | 
| | --------------------------------------------- |  | -------------- | ----- | 
| |                                               |  | (in thousands) |      
| |                                               |  |                |      
| |                                               |  |                |      
| | Current assets                                |  | $              | 1,336 | 
| | Other long term intangible
  assets           |  |                | 70    | 
| | Property and equipment,
  net                 |  |                | 100   | 
| |                                               |  |                |       | 
| | Customer related
  intangible asset (1)       |  |                | 498   | 
| | Technology (2)                                |  |                | 1,158 | 
| |                                               |  |                |       | 
| | Total tangible and intangible assets
acquired |  |                | 3,162 | 
| |                                               |  |                |       | 
| | Current liabilities                           |  |                | 1,360 | 
| | Other long term
  liabilities                 |  |                | 374   | 
| |                                               |  |                |       | 
| | Total liabilities assumed                     |  |                | 1,734 | 
| |                                               |  |                |       | 
| | Net assets acquired                           |  | $              | 1,428 | 
| |                                               |  |                |       | 

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                  
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------
|   | (1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | The value
  assigned to customer related intangibles is being amortized currently over 3
  years.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                  
|   | (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | The value
  assigned to technology is being amortized currently over 5 years.                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                  
|H. | Zulu
  Softwarre Inc.:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   | In
  February 2005, the Company entered into an agreement to purchase up to 20% of
  the outstanding share capital of Zulu Software, Inc. (Zulu), on a fully
  diluted basis. Under the purchase agreement, the purchase price was divided
  into four installments, each to be paid subject to fulfillment of certain
  milestones. The company paid the first installment of $350 thousand in
  February 2005 against the issuance of 8% of Zulus outstanding share capital.
  The Company did not make additional payments since the agreed upon milestones
  have not been met.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   | In
  January 2006, the Company purchased from the other shareholders of Zulu
  additional shares increasing its holdings to 72% of Zulus outstanding share
  capital. The aggregate consideration paid for this additional purchase was
  $2.4 million.                                                                                                                                                                                                                                                                                                                              

F  27

---

---



BLUEPHOENIX SOLUTIONS LTD.NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                               
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|H. | Zulu
  Softwarre Inc. (cont.):                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                               
|   | The
  consideration for the acquisition was attributed to net assets on the basis
  of fair value of assets acquired and liabilities assumed. Based upon a
  purchase price allocation, the purchase price was allocated to the purchased
  technology and is amortized over 5  years period.
|   |                                                                                                                                                                                                                                                                                               
|   | The following table
  summarizes the fair values of the assets acquired and liabilities assumed
  with reference to Zulus balance sheet as of the date of purchase.                                                                                                                          

| |                                               |  |                |       | 
| | --------------------------------------------- |  | -------------- | ----- | 
| |                                               |  | (in thousands) |      
| |                                               |  |                |      
| |                                               |  |                |       | 
| | Current assets                                |  | $              | 5     | 
| | Property and equipment,
  net                 |  |                | 4     | 
| | Technology                                    |  |                | 3,477 | 
| |                                               |  |                |       | 
| | Total tangible and intangible assets
acquired |  |                | 3,486 | 
| |                                               |  |                |       | 
| | Current liabilities                           |  |                | 340   | 
| | Other long term
  liabilities                 |  |                | 425   | 
| |                                               |  |                |       | 
| | Total liabilities assumed                     |  |                | 765   | 
| |                                               |  |                |       | 
| | Net assets acquired                           |  | $              | 2,721 | 
| |                                               |  |                |       | 

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|I. | Unaudited
  Pro Forma Information:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   | The following unaudited
  pro forma summary presents information as if the acquisition of Zulu and CodeStreams
  activity had occurred as of January 1, 2006, and 2005 and as if the
  acquisition of I-Ter had occurred as of January 1, 2005 and 2004. The pro
  forma information, which is provided for informational purposes only, is
  based on historical information and does not necessarily reflect the results
  that would have occurred, not is it necessarily indicative of future results
  of operations of the consolidated entity.

| |                                      |  |                                       |        |      |   |        |   |   |        |  
| | ------------------------------------ |  | ------------------------------------- | ------ | ---- | - | ------ | - | - | ------ | -
| |                                      |  | Year ended                            |       
| |                                      |  |                                       |       
| |                                      |  | December 31,                          |       
| |                                      |  |                                       |       
| |                                      |  | 2006                                  |        | 2005 |   | 2004   |  
| |                                      |  |                                       |       
| |                                      |  | (In thousands, except per share data) |       
| |                                      |  |                                       |       
| |                                      |  | (Unaudited)                           |       
| | Revenues                             |  | $                                     | 69,773 |      | $ | 61,301 |   | $ | 57,671 |  
| | Net income (loss)                    |  | $                                     | 3,599  |      | $ | (1,618 | ) | $ | (200   | )
| | Earning (loss) per share -
  basic   |  |                                       | 0.26   |      |   | (0.12  | ) |   | (0.01  | )
| | Earning (loss) per share -
  diluted |  |                                       | 0.25   |      |   | (0.12  | ) |   | (0.01  | )

F  28

---

---



BLUEPHOENIX SOLUTIONS LTD.NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2  Certain Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|J. | Cicero
  Inc. (formerly known as Level 8 Systems Inc.)                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   | As of December 31, 2006.
  the Company holds several capital instruments, including warrants and rights
  to receive warrants exercisable into shares of Cicero Inc. (Cicero). If the
  Company exercises these capital instruments in full, it will hold
  approximately 545,000 ordinary shares of Cicero. During 2003 and the first
  quarter of 2004 the company sold substantially all of the shares of Cicero
  held by the Company for $624 thousand.                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   | The Company provides Bank
  HaPoalim with a guarantee securing Ciceros bank loans, in an amount of
  approximately $2 million. The guarantee is extended from time to time and it
  is currently in effect until November 2007. In consideration for the extension of the
  guarantee, Cicero issues the Company ordinary shares. In the event that the
  guarantee is exercised, the bank is obligated to grant the Company a
  three-year loan in an amount of up to the amount of the guarantee.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   | In September 2004, the
  Company extended a loan granted to Cicero of approximately $97 thousand under
  a secured promissory note. The note bears interest at an annual rate of 10%.
  In consideration, the Company is entitled to receive warrants to purchase
  19,865 ordinary shares of Cicero at an exercise price of $1 per share.                                                                                                                                                           

Note 3  Property and Equipment, Net:

Composition of property and
equipment, grouped by major classifications:

|                          |                                      |   |                |        |      |       |        | 
|------------------------- | ------------------------------------ | - | -------------- | ------ | ---- | ----- | ------ | 
|                          |                                      |   | December 31,   |       
|                          |                                      |   |                |       
|                          |                                      |   | 2006           |        | 2005 |      
|                          |                                      |   |                |        |      |      
|                          |                                      |   | (in thousands) |       
|                          |                                      |   |                |       
|Cost:                     |                                      |   |                |        |      |       |       
|                          | Computers
  and peripheral equipment |   | $              | 9,887  |      | $     | 8,954  | 
|                          | Office
  furniture and equipment     |   |                | 1,268  |      |       | 1,403  | 
|                          | Leasehold
  improvements             |   |                | 645    |      |       | 644    | 
|                          | Motor
  vehicles                     |   |                | 292    |      |       | 464    | 
|                          |                                      |   |                |        |      |       |        | 
|                          |                                      |   |                | 12,092 |      |       | 11,465 | 
|                          |                                      |   |                |        |      |       |        | 
|Accumulated Depreciation: |                                      |   |                |        |      |       |       
|                          | Computers
  and peripheral equipment |   |                | 8,565  |      |       | 7,866  | 
|                          | Office
  furniture and equipment     |   |                | 874    |      |       | 872    | 
|                          | Leasehold
  improvements             |   |                | 398    |      |       | 358    | 
|                          | Motor
  vehicles                     |   |                | 108    |      |       | 209    | 
|                          |                                      |   |                |        |      |       |        | 
|                          |                                      |   |                | 9,945  |      |       | 9,305  | 
|                          |                                      |   |                |        |      |       |        | 
|Depreciated cost          |                                      | $ | 2,147          |        | $    | 2,160 |       
|                          |                                      |   |                |        |      |       |        | 

| |                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------
| | Depreciation expenses
  totaled $849, $1,058, and $1,380 thousand for the years ended December 31,
  2006, 2005, and 2004, respectively.

F  29

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 4  Goodwill:

| |                                         |  |                |        |      |   |        | 
| | --------------------------------------- |  | -------------- | ------ | ---- | - | ------ | 
| |                                         |  | December 31,   |       
| |                                         |  |                |       
| |                                         |  | 2006           |        | 2005 |  
| |                                         |  |                |        |      |  
| |                                         |  | (in thousands) |       
| |                                         |  |                |       
| | Carrying
  amounts at beginning of year |  | $              | 38,832 |      | $ | 37,090 | 
| | Acquired                                |  |                | 6,006  |      |   | 1,742  | 
| |                                         |  |                |        |      |   |        | 
| | Carrying
  amount at end of year        |  | $              | 44,838 |      | $ | 38,832 | 
| |                                         |  |                |        |      |   |        | 

Note 5  Software Development Costs and
Other:

|   |             
|-- | ------------
|A. | Composition:

December 31,2006

2005(in thousands)Software
  development costs (1)

$
34,823

$
25,810Customer
  related intangible assets (2)


1,067


453Deferred
  issuance expenses, net


738


328Rent deposit


57


119Deferred tax
  asset


-


13Others


141


177$
36,826

$
26,900(1)
Original
  amount

$
55,430

$
39,287Less -
  accumulated amortization


20,607


13,477$
34,823

$
25,810(2)
Original
  amount

$
1,576

$
923Less -
  accumulated amortization


509


470$
1,067

$
453 The estimated
aggregate amortization of customer related intangible asset for the following
years is as follows: 2007: $374 thousand, 2008: $255 thousand, 2009: $210
thousand,: 2010: $148, and 2011: $80thousand.


F  30

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 6  Short-Term Bank Credit and Other:

Composition:

| |                                          |  |                          |      |         |  |                     |  |      |     |  |   |        | 
| | ---------------------------------------- |  | ------------------------ | ---- | ------- |  | ------------------- |  | ---- | --- |  | - | ------ | 
| |                                          |  | Average 
  Interest rate |      |         |  |                     |  |      |     |  |   |       
| |                                          |  |                          |      |         |  |                     |  |      |     |  |   |       
| |                                          |  | December 31, 
  2006     |      | Linkage |  | December 31,
  2006 |  | 2005 |    
| |                                          |  |                          |      |         |  |                     |  |      |    
| |                                          |  | %                        |      | Basis   |  | (in thousands)      |  |      |     | 
| |                                          |  |                          |      |         |  |                     |  |      |     | 
|
| | Bank
  overdraft and loans               |  |                          | 7.5  |         |  | NIS                 |  | $    | 27  |  | $ | 2,654  | 
| | Short-term
  bank loans                  |  |                          | -    |         |  | CPI                 |  |      | -   |  |   | 12     | 
| | Short-term
  bank loans                  |  |                          | -    |         |  | Dollar              |  |      | -   |  |   | 5,556  | 
| | Promissory
  note to Fimi                |  |                          | -    |         |  | Dollar              |  |      | -   |  |   | 4,293  | 
| | Short-term
  bank loans                  |  |                          | 5.98 |         |  | Euro                |  |      | 55  |  |   | 1,580  | 
| | Current
  portion of long-term bank loan |  |                          | 5.84 |         |  | Euro                |  |      | 527 |  |   | -      | 
| |                                          |  |                          |      |         |  |                     |  |      |     |  |   |        | 
| |                                          |  |                          |      |         |  |                     |  | $    | 609 |  | $ | 14,095 | 
| |                                          |  |                          |      |         |  |                     |  |      |     |  |   |        | 

Note 7  Accrued Severance Pay, Net:

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Accrued Liability:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The Company
  is liable for severance pay to its employees pursuant to the applicable local
  laws prevailing in the respective countries of employment and employment
  agreements. For Israeli employees, the liability is partially covered by
  individual managers insurance policies under the name of the employee, for
  which the Company makes monthly payments. The Company may make withdrawals
  from the managers insurance policies only for the purpose of paying
  severance pay.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The amounts
  accrued and the amounts funded with managers insurance policies are as
  follows:                                                                                                                                                                                                                                                                                                                                                                                                    

| |                         |  |                |       |      |   |       | 
| | ----------------------- |  | -------------- | ----- | ---- | - | ----- | 
| |                         |  | December 31,   |      
| |                         |  |                |      
| |                         |  | 2006           |       | 2005 |  
| |                         |  |                |       |      |  
| |                         |  | (in thousands) |      
| |                         |  |                |      
|
| | Accrued
  severance pay |  | $              | 5,769 |      | $ | 4,733 | 
| | Less -
  amount funded  |  |                | 4,051 |      |   | 3,424 | 
| |                         |  |                |       |      |   |       | 
| |                         |  | $              | 1,718 |      | $ | 1,309 | 
| |                         |  |                |       |      |   |       | 

|   |                                                                                                                                                  
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Expenses:                                                                                                                                        
|   |                                                                                                                                                  
|   | The expenses
  related to severance pay for the years ended December 31, 2006, 2005, and
  2004 were $925, $383, and $766 thousand, respectively.

F  31

---

---



BLUEPHOENIX SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 8  Provision for Losses in Formerly-consolidated
Subsidiary:

Liraz, a wholly owned
subsidiary of the company, is liable for losses in a former subsidiary it had
consolidated until the second quarter of 2001. The provision for such liability
as of December 31, 2006 and December 31, 2005, was accounted for under SFAS No.
5 and amounted to $2 million, representing the maximum potential amount Liraz
has guaranteed to secure a bank loan of the said subsidiary. Under its terms,
such guarantee may be reduced to the extent that the subsidiary raises
additional share capital. The guarantee will be outstanding until November 2007
(see also Note 2J, with respect to the investment in Cicero).

Note 9  Loans from Banks
and Others:

|   |             
|-- | ------------
|A. | Composition:

|                        |  |         |        |                         |                   |                 |                   |                                                        |     |                                                        |   |        |  |   |       | 
|----------------------- |  | ------- | ------ | ----------------------- | ----------------- | --------------- | ----------------- | ------------------------------------------------------ | --- | ------------------------------------------------------ | - | ------ |  | - | ----- | 
|December 31,
  2006     |  |         |        |                         | December 31, 2006 |                 | December 31, 2005 |                                                       
|                        |  |         |        |                         |                   |                 |                   |                                                       
|Average
  Interest rate |  | Linkage |        | Long-term
  liabilities |                   | Current portion |                   | Total long-term
  liabilities net of
  current portion |     | Total long-term
  liabilities net of
  current portion |  
|                        |  |         |        |                         |                   |                 |                   |                                                        |     |                                                        |  
|                        |  |         |        |                         |                   |                 |                   |                                                       
|%                       |  | Basis   |        | (in thousands)          |                   | (in thousands)  |                  
|                        |  |         |        |                         |                   |                 |                  
|7.28                    |  |         | Dollar |                         | $                 | 10,554          |                   | $                                                      | -   |                                                        | $ | 10,554 |  | $ | 3,836 | 
|-                       |  |         | NIS    |                         |                   | -               |                   |                                                        | -   |                                                        |   | -      |  |   | 1,694 | 
|5.83                    |  |         | Euro   |                         |                   | 10,000          |                   |                                                        | 527 |                                                        |   | 9,473  |  |   | 2,859 | 
|                        |  |         |        |                         |                   |                 |                   |                                                        |     |                                                        |   |        |  |   |       | 
|                        |  |         |        |                         | $                 | 20,554          |                   | $                                                      | 527 |                                                        | $ | 20,027 |  | $ | 8,389 | 

|   |                                                                                                                                                                                                                 
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*  | The
  loans bear interest based on the LIBOR.                                                                                                                                                                   
|   |                                                                                                                                                                                                                 
|   | In
  connection with certain loan agreements, the Company committed to certain covenants related to its operation
   see Note 10.A.10. As of December
  31, 2006, The Company met all such financial covenants.
|   |                                                                                                                                                                                                                 
|B. | Long-term Loans from Banks and Other are Due as Follows:                                                                                                                                                        

|                               |  |                |        |      |   |       | 
|------------------------------ |  | -------------- | ------ | ---- | - | ----- | 
|                               |  | December 31,   |       
|                               |  |                |       
|                               |  | 2006           |        | 2005 |  
|                               |  |                |        |      |  
|                               |  | (in thousands) |       
|                               |  |                |       
|First year (current
  portion) |  | $              | 527    |      | $ | 355   | 
|Second year                    |  |                | 7,558  |      |   | 2,227 | 
|Third year                     |  |                | 1,620  |      |   | 4,150 | 
|Fourth year and thereafter     |  |                | 10,849 |      |   | 2,012 | 
|                               |  |                |        |      |   |       | 
|Total                          |  | $              | 20,554 |      | $ | 8,744 | 
|                               |  |                |        |      |   |       | 

F  32

---

---



BLUEPHOENIX SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 10  Commitments and Contingencies:

|   |             
|-- | ------------
|A. | Commitments:

| |    |                                                                                                                                                                                                                       
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. | The Company is obligated
  to pay management fees to Formula in an annual amount equal to 3% of the
  revenues, but not more than $180 thousand.                                                                      
| |    |                                                                                                                                                                                                                       
| | 2. | The Company rents its
  offices, vehicles and, other equipment under various operating lease
  agreements. Aggregate minimum rental commitments under non-cancelable leases
  as of December 31, 2006 were as follows:

|            |  |                     |       |                                    |   |       | 
|----------- |  | ------------------- | ----- | ---------------------------------- | - | ----- | 
|            |  | Office
  Facilities |       | Vehicles,
  Equipment, and
  Other |  
|            |  |                     |       |                                    |  
|Fiscal 2007 |  | $                   | 1,837 |                                    | $ | 1,226 | 
|Fiscal 2008 |  |                     | 1,209 |                                    |   | 800   | 
|Fiscal 2009 |  |                     | 258   |                                    |   | 244   | 
|Fiscal 2010 |  |                     | 119   |                                    |   | 4     | 
|Thereafter  |  |                     | 44    |                                    |   | -     | 
|            |  |                     |       |                                    |   |       | 
|            |  | $                   | 3,467 |                                    | $ | 2,274 | 
|            |  |                     |       |                                    |   |       | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3. | Under agreements between
  the Company and certain of its customers, the Company undertook to provide
  such customers a bank guarantee for the assurance of performance of its
  obligations under its agreements with such customers. As of December 31,
  2006, there are outstanding bank guarantees on behalf of customers in the
  aggregate amount of $360 thousand.                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | 4. | Through December 31, 2006,
  Mainsoft entered into a grant agreement with the OCS, for the development of
  Visual MainWin for J2EE.                                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | Royalties of 3% are
  payable to the OCS on sales of Visual MainWin for J2EE up to 100% of the
  dollar-linked grant received with regard to funded product.                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | The balance of the
  contingent liability relating to the above royalties as of December 31, 2006
  amounted to approximately $1.8 million.                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | 5. | As of January 1, 2004 a wholly owned subsidiary entered
  into a grant agreement with the OCS, for the development of PowerText.
  Royalties of 3% are payable to the OCS on sales of PowerText up to 100% of
  the dollar-linked grant received with regard to the funded product. As of
  December 31, 2006 the balance of the contingent liability relating to the
  above royalties amounted to approximately $235 thousand.

F  33

---

---



BLUEPHOENIX SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 10  Commitments and Contingencies
(cont.):

|   |                     
|-- | --------------------
|A. | Commitments (cont.):

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6.  | Through December 31, 2004, MultiConn Technologies
  entered into a grant agreement with the OCS, for the development of
  WS4Legacy, (formerly known as eXperanto). Royalties of 3% are payable to the OCS on sales of WS4Legacy up
  to 100% of the dollar-linked grant received in regard to the funded product.                                                                                                                                                                                                                                                                                                               
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |     | The balance
  of the contingent liability relating to the above royalties at December 31,
  2006 amounted to approximately $615 thousand.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | 7.  | As to a guarantee of debt by Cicero  see Note 8.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | 8.  | In 2004, the
  Singapore-Israel Industrial Research and Development Foundation agreed to
  provide a wholly owned subsidiary of the Company together with a Company
  incorporated in Singapore, financing for the development of a Java report
  generator based on legacy text file input. Accordingly, the foundation agreed
  to award the subsidiary up to $100 thousand repayable according to an agreed
  schedule. As of December 31, 2006, the subsidiary received $45 thousand of
  the grant. The grant is required to be repaid in installments based on sales
  of the funded product up to the amount of the grant.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | 9.  | The Companys subsidiary, I-Ter, is entitled to funds
  to developeEasy4Plan product from the Ministry of Production in Italy.
  Easy4Plan is a workflow management tool designed for ISO9000 companies.
  Approximately 30% of the funds are a grant, and the balance is an 8-year loan
  to be repaid by I-Ter. The loan bears a minimal annual interest. The
  development period ended in September 2006. Pending the final approval of the
  Ministry of Production, the Company anticipates that during 2007 I-Ter will
  receive a total aggregate amount of $650 thousand.                                               
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | 10. | In
  connection with the credit line extended to the Company by Bank Leumi
  LeIsrael Ltd., Bank Discount LeIsrael Ltd, Bank HaPoalim Ltd., and the
  First International Bank Ltd., the Company committed to certain covenants
  related to its operation such as:                                                                                                                                                                                                                                                                                                                                                           

| |    |                                                                                                                                        
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------
| | a) | Maintaining
  a minimum level of shareholders equity of no less than 40% of the Companys
  total assets and no less than $40 million;
| |    |                                                                                                                                        
| | b) | Maintaining
  a level of annual operating income before depreciation and amortization of no
  less than $5 million; and                
| |    |                                                                                                                                        
| | c) | Maintaining
  the ratio of the Company bank liabilities to current assets, excluding other
  current assets, of no more than 55%.      

F  34

---

---



BLUEPHOENIX SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 10  Commitments and Contingencies
(cont.):

|   |                     
|-- | --------------------
|A. | Commitments (cont.):

| |     |        
| | --- | -------
| | 10. | (Cont.)

| |                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | As of
  December 31, 2006, the Company met all such financial covenants.                                                                                                        
| |                                                                                                                                                                                 
| | No liability
  was recorded in the Companys financial statements with respect to the
  guarantees mentioned above, except for the guarantee on behalf of Cicero (see
  Note 8),

|   |               
|-- | --------------
|B. | Contingencies:

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. | In July 2003, a former Liraz shareholder filed an
  application with the Tel-Aviv-Jaffa District Court to approve a claim filed
  by him against the Company, as a class action. The claim relates to the
  acquisition of Liraz shares that the Company completed in March 2003. The
  shareholder alleges that the share price that the Company paid to Lirazs
  shareholders in the tender offer and in a subsequent mandatory purchase was
  lower than the fair price of Liraz shares. The maximum amount of the claim is
  approximately $7.3 million in the aggregate. Under Israeli law, the courts
  approval is required for the plaintiff to represent all of the shareholders
  of Liraz who sold their shareholdings to the Company pursuant to the tender
  offer and the mandatory acquisition. The plaintiff has applied for such
  approval in the lawsuit. The
  Company believes that the allegations against it in this proceeding are
  without merit and intends to vigorously defend the claim and contest the
  allegations made therein.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | 2. | The Company
  evaluates estimated losses for indemnifications due to product infringement
  under SFAS No. 5, Accounting for Contingencies, as interpreted by FIN 45. At this time, it is not
  possible to determine
  the maximum potential amount under these indemnification clauses due to lack
  of prior indemnification claims and the unique facts and circumstances involved in each particular
  agreement. Such indemnification agreements may not be subject to maximum loss clauses. Historically,
  we have not incurred
  material costs as a result of obligations under these agreements and we have not accrued any liabilities related
  to such indemnification obligations in our financial statements.                                                                                                                                                                                                                                                                                                                                    

F  35

---

---



BLUEPHOENIX SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11 
Shareholders Equity:

|   |               
|-- | --------------
|A. | Share Capital:

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. | On January
  31, 1997, 3,120,000 ordinary shares of the Company were offered in an initial
  public offering (the IPO) at a price of $7.50 per share. Since the above
  transaction, the Companys shares have been traded in the United States on
  the Nasdaq Global Market. Their current symbol is BPHX.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 2. | On July 22,
  1997, 1,200,000 ordinary shares of the Company were offered in a second
  public offering, at a price of $27.00 per share, of which 600,000 ordinary
  shares were issued by the Company and 600,000 ordinary shares were sold by
  existing shareholders.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 3. | During the years 1998 through 2002, two subsidiaries of the Company
  purchased a total of 1,870,565 the Companys shares for a total consideration
  of $14.7 million. All of the Companys ordinary shares have equal voting
  rights. However, under applicable Israeli law, the shares held by the
  Companys subsidiaries have no voting rights and, therefore, are excluded
  from the number of its outstanding shares. In January 2006, the Companys
  subsidiary sold an aggregate of 136,000 of the shares held by it to Israeli
  institutional investors in Israel, for aggregate consideration of
  approximately $534 thousand. In February 2006, the Companys subsidiary
  transferred 86,791 shares to Outlook Systems and BluePhoenix issued 51,620
  ordinary shares on its behalf (See note 2.D).
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 4. | In January
  2001, the Companys ordinary shares were listed for trading on the Tel Aviv
  Stock Exchange under the Dual Listing arrangement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 5. | In November
  2002, the Company issued to Lirazs selling shareholders, including Formula,
  3,478,624 ordinary shares, constituting an aggregate of 26% of the Companys
  outstanding share capital.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 6. | In the first
  quarter of 2007 FIMI exercised 210,000 warrants (see note 2.E)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 7. | In the first
  quarter of 2007, the Company issued to Infinity 100,719 ordinary shares (see
  Note 2.E.).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

|   |               
|-- | --------------
|B. | Share Options:

| |    |                             
| | -- | ----------------------------
| | 1. | Employee Share Option Plans:

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | The 1996 Share Option Plan:                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | In 1996, the
  Company adopted two option plans. One of these option plans was terminated
  after all options granted under it were exercised. Pursuant to the other 1996
  option plan, as amended, the Company reserved 3,700,000 ordinary shares for
  issuance to directors, officers, consultants and employees of the Company and
  its subsidiaries. The exercise price of the options granted under the 1996
  option plan ranges from $2.25 to $10.50.

F  36

---

---



BLUEPHOENIX
SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11  Shareholders Equity (cont.):

|   |                          |                                        |                                                                                                                                                                                                                                              
|-- | ------------------------ | -------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share
  Options (cont.):
|   |                          |                                        |                                                                                                                                                                                                                                              
|   | 1.                       | Employee
  Share Option Plans (cont.):
|   |                          |                                        |                                                                                                                                                                                                                                              
|   |                          | a)                                     | The
  1996 Share Option Plan (cont.):                                                                                                                                                                                                        
|   |                          |                                        |                                                                                                                                                                                                                                              
|   |                          |                                        | Under the 1996 option plan, unless determined
  otherwise by the Board, options vest over a three-year period from the date
  of grant and expire 10 years after grant date. Unvested options are forfeited
  upon termination of employment.
|   |                          |                                        |                                                                                                                                                                                                                                              
|   |                          |                                        | The following table summarizes information about
  fixed share options outstanding at December 31, 2006:                                                                                                                                     

| |                              |  |                                               |                     |                                                     |                     |                                       |       |                                                 |  |                                       |  |       |  | 
| | ---------------------------- |  | --------------------------------------------- | ------------------- | --------------------------------------------------- | ------------------- | ------------------------------------- | ----- | ----------------------------------------------- |  | ------------------------------------- |  | ----- |  | 
| |                              |  |                                               | Options Outstanding |                                                     | Options Exercisable |                                      
| |                              |  |                                               |                     |                                                     |                     |                                      
| | Range of
  Exercise
  Prices |  | Number
  Outstanding
  on December
  31, 2006 |                     | Weighted
  Average
  Remaining
  Contractual
  Life |                     | Weighted
  Average
  Exercise
  Price |       | Number
  Exercisable
  on
  December
  31, 2006 |  | Weighted
  Average
  Exercise
  Price | 
| |                              |  |                                               |                     |                                                     |                     |                                       |       |                                                 |  |                                       | 
| | $                            |  |                                               |                     | Years                                               |                     | $                                     |       |                                                 |  | $                                     | 
| |                              |  |                                               |                     |                                                     |                     |                                       |       |                                                 |  |                                       | 
| | 2.25                         |  |                                               | 395,000             |                                                     | 6.25                |                                       | 2.25  |                                                 |  | 291,000                               |  | 2.25  |  | 
| | 3.00                         |  |                                               | 106,701             |                                                     | 6.50                |                                       | 3.00  |                                                 |  | 106,701                               |  | 3.00  |  | 
| | 3.00                         |  |                                               | 63,600              |                                                     | 5.50                |                                       | 3.00  |                                                 |  | 63,600                                |  | 3.00  |  | 
| | 3.00                         |  |                                               | 80,000              |                                                     | 5.09                |                                       | 3.00  |                                                 |  | 53,333                                |  | 3.00  |  | 
| | 3.50                         |  |                                               | 34,700              |                                                     | 6.50                |                                       | 3.50  |                                                 |  | 34,700                                |  | 3.50  |  | 
| | 4.00                         |  |                                               | 200,000             |                                                     | 6.83                |                                       | 4.00  |                                                 |  | 200,000                               |  | 4.00  |  | 
| | 4.00                         |  |                                               | 150,000             |                                                     | 9.00                |                                       | 4.00  |                                                 |  | 150,000                               |  | 4.00  |  | 
| | 4.50                         |  |                                               | 38,533              |                                                     | 4.50                |                                       | 4.50  |                                                 |  | 38,533                                |  | 4.50  |  | 
| | 4.50                         |  |                                               | 63,000              |                                                     | 8.67                |                                       | 4.50  |                                                 |  | 63,000                                |  | 4.50  |  | 
| | 5.00                         |  |                                               | 37,400              |                                                     | 8.83                |                                       | 5.00  |                                                 |  | 37,400                                |  | 5.00  |  | 
| | 5.00                         |  |                                               | 430,712             |                                                     | 9.00                |                                       | 5.00  |                                                 |  | 430,712                               |  | 5.00  |  | 
| | 5.50                         |  |                                               | 13,000              |                                                     | 3.83                |                                       | 5.50  |                                                 |  | 13,000                                |  | 5.50  |  | 
| | 5.50                         |  |                                               | 75,000              |                                                     | 9.58                |                                       | 5.50  |                                                 |  | -                                     |  | 5.50  |  | 
| | 6.00                         |  |                                               | 28,000              |                                                     | 7.00                |                                       | 6.00  |                                                 |  | 28,000                                |  | 6.00  |  | 
| | 6.00                         |  |                                               | 143,721             |                                                     | 7.42                |                                       | 6.00  |                                                 |  | 143,721                               |  | 6.00  |  | 
| | 6.00                         |  |                                               | 150,000             |                                                     | 8.67                |                                       | 6.00  |                                                 |  | 150,000                               |  | 6.00  |  | 
| | 6.50                         |  |                                               | 2,000               |                                                     | 7.00                |                                       | 6.50  |                                                 |  | 2,000                                 |  | 6.50  |  | 
| | 8.00                         |  |                                               | 80,000              |                                                     | 2.50                |                                       | 8.00  |                                                 |  | 80,000                                |  | 8.00  |  | 
| | 9.63                         |  |                                               | 43,000              |                                                     | 3.25                |                                       | 9.63  |                                                 |  | 43,000                                |  | 9.63  |  | 
| | 10.50                        |  |                                               | 88,600              |                                                     | 4.25                |                                       | 10.50 |                                                 |  | 88,600                                |  | 10.50 |  | 
| |                              |  |                                               |                     |                                                     |                     |                                       |       |                                                 |  |                                       |  |       |  | 
| |                              |  |                                               | 2,222,967           |                                                     |                     |                                       |       |                                                 |  | 2,017,300                             |  |       |  | 
| |                              |  |                                               |                     |                                                     |                     |                                       |       |                                                 |  |                                       |  |       |  | 

F  37

---

---



BLUEPHOENIX
SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11  Shareholders Equity (cont.):

|   |                          |                                        |                                                                                                                                                                                                                                                                                                                                                                                                                             
|-- | ------------------------ | -------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share
  Options (cont.):
|   |                          |                                        |                                                                                                                                                                                                                                                                                                                                                                                                                             
|   | 1.                       | Employee
  Share Option Plans (cont.):
|   |                          |                                        |                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                          | b)                                     | Options granted to employees of a
  subsidiary:                                                                                                                                                                                                                                                                                                                                                                             
|   |                          |                                        |                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                          |                                        | In August 2000, in connection with the purchase of a
  controlling interest in a subsidiary, the Company granted options to certain
  employees of the subsidiary to purchase an aggregate of 125,000 of the
  Companys ordinary shares of which 55,000 were cancelled. The exercise price
  of the options is $9.625 per share. All of these options are currently
  exercisable. The options shall expire in August 2010.
|   |                          |                                        |                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                          |                                        | Data related to the share option plan as of December
  31, 2006, 2005 and 2004 and changes during the years ended on those dates are
  as follows:                                                                                                                                                                                                                                                                          

| |                                                                   |  |                       |   |                                       |  |                       |   |                                       |  |                       |   |                                       | 
| | ----------------------------------------------------------------- |  | --------------------- | - | ------------------------------------- |  | --------------------- | - | ------------------------------------- |  | --------------------- | - | ------------------------------------- | 
| |                                                                   |  | 2006                  |   | 2005                                  |  | 2004                  |  
| |                                                                   |  |                       |   |                                       |  |                       |  
| |                                                                   |  | Number
  of
  Options |   | Weighted
  Average
  Exercise
  Price |  | Number
  of
  Options |   | Weighted
  Average
  Exercise
  Price |  | Number
  of
  Options |   | Weighted
  Average
  Exercise
  Price | 
| |                                                                   |  |                       |   |                                       |  |                       |   |                                       |  |                       |   |                                       | 
| |                                                                   |  |                       |   | $                                     |  |                       |   | $                                     |  |                       |   | $                                     | 
| |                                                                   |  |                       |   |                                       |  |                       |   |                                       |  |                       |   |                                       | 
|
| | Options
  outstanding at beginning of year                        |  | 2,765,817             |   | 4.78                                  |  | 2,132,587             |   | 5.00                                  |  | 2,159,993             |   | 4.99                                  | 
|
| | Changes during
  the year:                                        |  |                       |   |                                       |  |                       |   |                                       |  |                       |   |                                       | 
|
| | Granted                                                           |  | 75,000                |   | 5.5                                   |  | 834,712               |   | 4.96                                  |  | 163,721               |   | 6.00                                  | 
|
| | Exercised                                                         |  | (206,796              | ) | 3.53                                  |  | (10,299               | ) | 3.05                                  |  | (33,767               | ) | 3.56                                  | 
|
| | Forfeited                                                         |  | (411,054              | ) | 6.19                                  |  | (191,183              | ) | 8.04                                  |  | (157,360              | ) | 6.29                                  | 
| |                                                                   |  |                       |   |                                       |  |                       |   |                                       |  |                       |   |                                       | 
| | Options outstanding
  at end of year                              |  | 2,222,967             |   | 4.60                                  |  | 2,765,817             |   | 4.78                                  |  | 2,132,587             |   | 5.00                                  | 
| |                                                                   |  |                       |   |                                       |  |                       |   |                                       |  |                       |   |                                       | 
| | Options
  exercisable at year-end                                 |  | 2,017,300             |   | 4.71                                  |  | 2,399,484             |   | 4.78                                  |  | 877,049               |   | 6.08                                  | 
| |                                                                   |  |                       |   |                                       |  |                       |   |                                       |  |                       |   |                                       | 
| | Weighted-average
  fair value of options granted during the year* |  | 2.65                  |   |                                       |  | 1.47                  |   |                                       |  | 1.71                  |   |                                       | 
| |                                                                   |  |                       |   |                                       |  |                       |   |                                       |  |                       |   |                                       | 

| |   |                                                                                                                                                                                                                                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | The fair value of each option granted is estimated
  on the date of grant, using the Black-Scholes option-pricing model with the
  following weighted average assumptions: dividend yield of 0% for all years;
  expected volatility: 2006  45%, 2005 - 41%, 2004 - 26%; risk-free interest
  rate: 2006- 4.97%, 2005 - 3.93%, 2004 - 2.78%; and expected life: 2006 and
  2005 - 5.5 years, 2004 - 3 years.

F  38

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11  Shareholders Equity
(cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|-- | ---------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                       
|   | 1.                     | Employee Share Option Plans (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | c)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | Acceleration:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | In anticipation of the
  effects that adoption of SFAS No. 123R would have, and under the Companys management belief
  that in the currently increasing competition in the labor market, an
  acceleration may have a positive effect on employee morale and retention, the Compensation Committee and Board of
  Directors approved and made effective on December 27, 2005 the acceleration
  of several unvested stock options. As a result, 144,990 and 1,228,997
  unvested stock options were accelerated in the Company and in its subsidiary,
  respectively.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   | 2.                     | Convertible
  Debentures and Warrants:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | On March 30, 2004, the
  Company completed a $5 million private placement of convertible debentures
  and warrants to four institutional investors. On February 18, 2005, the
  institutional investors and the Company amended certain terms of this
  transaction.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | Pursuant to the amended
  agreement, the debentures are due in 2007 and bear interest at a rate equal
  to the six-month LIBOR, paid quarterly in cash or in a number of BluePhoenix
  ordinary shares, at the Companys discretion. The debentures are convertible
  into BluePhoenixs ordinary shares at a conversion rate of $5.25 per ordinary
  share, subject to (i) adjustment for stock dividends, stock splits,
  recapitalization and other similar events, and (ii) anti-dilution adjustments.
  Following an event of adjustment in January 2006, the conversion rate of the
  debentures was adjusted to $5.24 per ordinary share. The conversion rate with
  respect to payments of interest on the debentures will be equal to 90% of the
  volume weighted average price of BluePhoenix ordinary shares on the  Nasdaq Global market during the 20 trading days preceding the date of payment of
  interest. In the event that the volume weighted average price per ordinary
  share (as calculated in the preceding sentence) for any 20 consecutive
  trading days exceeds $6.55, the Company may force the holders of the
  debentures to convert any or all of the principal amount of the debentures
  held by them as of such date, subject to, among other things, the Company
  having an effective resale registration statement at such time for the resale
  of the ordinary shares underlying the debentures.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | In addition to the
  debentures, the institutional investors were issued warrants to purchase up
  to 285,714 BluePhoenix ordinary shares at an exercise price of $6.50 per
  share, subject to adjustments similar to those pertaining to the conversion
  price of the debentures. The warrants are exercisable during a 5-year period
  commencing September 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

F  39

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11  Shareholders Equity
(cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-- | ---------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                       
|   | 2.                     | Convertible Debentures and Warrants (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                        | As agreed with the
  investors, the registered shares underlying the debentures and warrants are
  registered for resale under the effective registration statement. In
  accordance with APB No. 14, Accounting for Convertible Debt and Debt Issued
  with Stock Purchase Warrants, EITF 98-5, Accounting for Convertible
  Securities with Beneficial Conversion Features or Contingently Adjustable
  Conversion Rations, and EITF 00-27, Application of Issue No. 98-5 to
  Certain Convertible Instruments (EITF 00-27), a portion of the proceeds of
  the convertible debentures issued with detachable warrants was allocated to
  the warrants and to the convertible instrument at the time of issuance.
  Amounts allocated to the warrants were accounted for as liabilities, in
  accordance with EITF 00-19, Accounting for Derivative Financial Instruments
  Indexed to, and Potentially Settled In, a Companys Own Stock, and were
  revalued, based on the fair values of the underlying shares, on each
  reporting date, against financial expenses (income). The financial expenses
  relating to the change in the value of the warrants derivative amounted to
  $104 thousand and $45 thousand for the years ended 2004 and 2005,
  respectively.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                        | Since any future dilutive
  issuance is under the control of the Company, and the anti-dilution
  adjustment is limited, the Company accounted the debentures as conventional
  convertible instruments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                        | As a result, at the
  issuance date, a beneficial conversion feature was recorded on the
  debentures, in the amount of $173 thousand, since the effective conversion
  price of the debentures was lower than the fair value of the shares on the
  commitment date.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                        | The
  Company applied EITF 96-19 Debtors Accounting for a Modification or
  Exchange of Debt Instruments and EITF 05-7 Accounting of Modification to
  Conversion Option Embedded in Debt Securities and Related Issues to
  determine the accounting for the modification on February 18, 2005. The
  change in the term of the convertible debentures was accounted for as a
  modification of the instrument as a result of the application of the 10% test
  on the modified debenture and the original debenture. As a result the change
  in the debt instrument is not considered substantially different (less then
  10%).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

F  40

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11  Shareholders Equity
(cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-- | ---------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                       
|   | 2.                     | Convertible Debentures and Warrants (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | A new effective interest
  rate was determined based on the carrying amount of the original debt
  instrument and the revised cash flows. The deemed discount of the debentures
  is deducted from the liability and the issuance expenses, which are recorded
  as an asset, and is amortized using the interest method over a period of 44
  months, the term of the debentures.                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | The difference between the
  fair value of the conversion option immediately following such modification
  and the fair value immediately prior to the modification, was recognized as a
  discount associated with the debt, and the offset to the discount was
  recognized in equity in accordance with EITF 05-7 in the amount of $325
  thousand. The difference between the fair value of the modified warrants and
  the fair value of the original warrants (the warrants are revaluated based on
  the fair values of the underling shares) was deducted from the warrant
  derivative against a discount. The financial expense relating to the
  amortization of the discount of the debentures amounted to $217, $276 and
  $303 thousand for the years ended December 31, 2004, 2005 and 2006,
  respectively.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | On March 15, 2005, as the
  Form F-3 relating to the convertible debentures was declared effective by the
  Securities Exchange Commission, the Company classified the fair value
  attributed to the warrants as equity. The warrants were revaluated to their
  fair value until such date.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | In November 2006, several
  investors converted $178 thousand principal amount of the debentures into
  equity and accordingly the company issued 33,800 ordinary shares.
  Consequently, the respective unamortized discount and the beneficial
  conversion feature were charged to earnings.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | Pursuant to the Companys
  agreement with the institutional investors, in March 2006, three of the
  investors exercised their right to purchase additional debentures and
  warrants. Accordingly, the Company issued to the investors debentures in an
  aggregate purchase price of $3 million on the same terms as the initial
  debentures, except that the conversion price is $4.50 per share and is due in
  2009.                                                                                                                                                                                                                                                                                                                                                                                                
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                        | In addition, the
  institutional investors were issued additional warrants on the same terms as
  the initial warrants, to purchase an aggregate of up to 200,000 BluePhoenix
  ordinary shares. The warrants are exercisable during a 5-year period
  commencing on September 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

F  41

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11  Shareholders Equity
(cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-- | ---------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                       
|   | 2.                     | Convertible Debentures and Warrants (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                        | In the event that the
  volume weighted average price per ordinary share (as calculated in the
  preceding sentence) for any 20 consecutive trading days exceeds $5.625, the
  Company may force the holders of the debentures to convert any or all of the
  principal amount of the debentures held by them as of such date, subject to,
  among other things, the Company having an effective resale registration
  statement at such time for the resale of the ordinary shares underlying the
  debentures.                                                                                                                                                                                                                                                                                                               
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                        | In accordance with APB No.
  14, Accounting for Convertible Debt and Debt Issued with Stock Purchase
  Warrants, a portion of the proceeds of the convertible debentures issued
  with detachable warrants was allocated to the warrants and to the convertible
  instrument at the time of issuance. Amounts allocated to the warrants were
  accounted for as liabilities, in accordance with EITF 00-19, Accounting for
  Derivative Financial Instruments Indexed to, and Potentially Settled In, a
  Companys Own Stock, and were revalued, based on the fair values of the
  underlying shares, on each reporting date, against financial expenses
  (income). The financial income relating to the change in the value of the
  warrants derivative amounted to $9 thousand for the year ended December 31,
  2006.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                        | Since the debentures
  include an anti-dilution adjustment and the conversion price is not fixed,
  the Company recorded the embedded conversion feature at fair value in the
  amount of $1.35 million and its being marked to market in accordance with
  EITF 00-19 and EITF 05-02 Meaning of Conventional Convertible Debt
  Instrument in Issue No. 00-19. Financial expenses relating to the reevaluation
  of the conversion feature amounted to $82 thousand in fiscal 2006.                                                                                                                                                                                                                                                                                                                                        
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                        | In May 2006, as the Form
  F-3 relating to the convertible debentures was declared effective by the
  Securities Exchange Commission, the Company classified the fair value attributed
  to the warrants as equity. The warrants were revaluated to their fair value
  until such date.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                        | During the fourth quarter
  of 2006, several investors converted $1 million principal amount of the
  debentures into equity and accordingly were issued 223,333 ordinary shares.
  Consequently, the relative carrying amount of the debentures and the embedded
  conversion features were charged to equity.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

F  42

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11  Shareholders Equity (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|-- | ---------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                       
|   | 3.                     | In February 2006, the
  Company completed an underwritten public offering in Israel of series A
  convertible notes in an aggregate principal amount of NIS 54 million that
  were equal at that time to approximately $11.5 million. The price of the
  notes as determined in the offering was 98% of the principal amount of the
  notes, and the gross proceeds from the offering of the notes totaled $11.2
  million. The notes bear interest at a rate of LIBOR 3 months +1.5% per annum,
  payable every 3 months beginning on May 1, 2006, with the last payment to be
  made on February 1, 2011. The principal of the notes is payable in four equal
  annual installments on February 1 of each of 2008 through 2011. The principal
  and interest of the notes are linked to the U.S. Dollar, with a minimum rate
  of the issuance date exchange rate. Under certain terms, the Company may call
  for an early redemption of the notes, after February 1, 2008. The notes are
  convertible into ordinary shares of BluePhoenix at a conversion rate of one
  ordinary share per NIS 26 ($6.15) principal amount of notes, subject to
  adjustments. Holders may convert their notes into BluePhoenix ordinary shares
  on any trading day, beginning on the date the notes were first listed for trading
  until the closing of trade on January 16, 2011. The convertible notes are not
  secured.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                        | The notes are traded on
  the TASE. The notes and the shares underlying the notes have not been
  registered under the Securities Act, and may not be offered or sold in the
  United States or to U.S. persons, absent registration or an applicable
  exemption from registration requirements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                        | The minimum
  level of the exchange rate was accounted for as an embedded put option and
  accordingly was bifurcated from the host debt contract. The put option was
  recorded at fair value on the issuance date and is being marked to market in
  accordance with SFAS No 133 Accounting for Derivative Instruments and
  Hedging Activities. During 2006, financial expenses amounted to $808
  thousand in connection with the granted put option.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

F  43

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11  Shareholders Equity (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                            
|-- | ---------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                        |                                                                                                                                                                                                                                                                                                            
|   | 4.                     | Employee Option Plans in a Subsidiary:                                                                                                                                                                                                                                                                     
|   |                        |                                                                                                                                                                                                                                                                                                            
|   |                        | A subsidiary
  granted options to its employees to purchase the subsidiarys shares. The
  options are exercisable during a 3-year period after the date of grant. A
  summary of the status of the option plans as of December 31, 2006 and 2005
  and changes during the years then ended is given below:

| |                                                                    |  |                     |           |                                       |  |                     |  |                                       |           |   |  |      | 
| | ------------------------------------------------------------------ |  | ------------------- | --------- | ------------------------------------- |  | ------------------- |  | ------------------------------------- | --------- | - |  | ---- | 
| |                                                                    |  | 2006                |           | 2005                                  | 
| |                                                                    |  |                     |           |                                       | 
| |                                                                    |  | Number of
  Options |           | Weighted
  Average
  Exercise
  Price |  | Number of
  Options |  | Weighted
  Average
  Exercise
  Price |          
| |                                                                    |  |                     |           |                                       |  |                     |  |                                       |          
| |                                                                    |  |                     |           | $                                     |  |                     |  | $                                     |          
| |                                                                    |  |                     |           |                                       |  |                     |  |                                       |          
| | Options outstanding at beginning of year                           |  |                     | 4,679,487 |                                       |  | 0.84                |  |                                       | 4,463,487 |   |  | 0.97 | 
|
| | Changes during the year:                                           |  |                     |           |                                       |  |                     |  |                                       |           |   |  |      | 
|
| | Granted                                                            |  |                     | -         |                                       |  |                     |  |                                       | 426,000   |   |  | 0.65 | 
|
| | Exercised                                                          |  |                     | -         |                                       |  |                     |  |                                       | -         |   |  |      | 
|
| | Forfeited/cancelled                                                |  |                     | (295,500  | )                                     |  | 0.85                |  |                                       | (210,000  | ) |  | 0.85 | 
| |                                                                    |  |                     |           |                                       |  |                     |  |                                       |           |   |  |      | 
| | Options outstanding at end of year                                 |  |                     | 4,383,987 |                                       |  | 0.84                |  |                                       | 4,679,487 |   |  | 0.84 | 
| |                                                                    |  |                     |           |                                       |  |                     |  |                                       |           |   |  |      | 
| | Options exercisable at year-end                                    |  |                     | 4,383,987 |                                       |  | 0.84                |  |                                       | 4,679,487 |   |  | 0.84 | 
| |                                                                    |  |                     |           |                                       |  |                     |  |                                       |           |   |  |      | 
| | Weighted-average fair value of options
  granted during the year * |  |                     | -         |                                       |  |                     |  |                                       | 0.22      |   |  |      | 
| |                                                                    |  |                     |           |                                       |  |                     |  |                                       |           |   |  |      | 

| |                                                                                                            |                                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | *                                                                                                          | The fair
  value of each option granted is estimated on the date of grant, using the
  Black-Scholes option-pricing model with the following weighted average
  assumptions: dividend yield of 0% for all years; expected volatility: 2005 -
  44%; risk-free interest rate: 2005 - 3.93%, and expected life: 2005 - 3
  years.
| |                                                                                                            |                                                                                                                                                                                                                                                                                                                                
| | The
  following table summarizes information about fixed share options outstanding
  at December 31, 2006:

|                               |  |                                               |           |                                                 |  |                                       |  |                                               |  |                                         |           |           |      |  |  | 
|------------------------------ |  | --------------------------------------------- | --------- | ----------------------------------------------- |  | ------------------------------------- |  | --------------------------------------------- |  | --------------------------------------- | --------- | --------- | ---- |  |  | 
|                               |  | Options Outstanding                           |           | Options Exercisable                             | 
|                               |  |                                               |           |                                                 | 
|Range
  of
  Exercise
  Prices |  | Number
  Outstanding
  at December
  31, 2006 |           | Weighted Average
  Remaining
  Contractual Life |  | Weighted
  Average
  Exercise
  Price |  | Number
  Exercisable
  at December
  31, 2006 |  | Weighted
  Average 
  Exercise 
  Price |          
|                               |  |                                               |           |                                                 |  |                                       |  |                                               |  |                                         |          
|$                              |  |                                               |           | Years                                           |  | $                                     |  |                                               |  | $                                       |          
|                               |  |                                               |           |                                                 |  |                                       |  |                                               |  |                                         |          
|0.10.50                       |  |                                               | 783,421   |                                                 |  | 9.58                                  |  | 0.26                                          |  |                                         | 783,421   |           | 0.26 | 
|0.65                           |  |                                               | 2,479,173 |                                                 |  | 6.33                                  |  | 0.65                                          |  |                                         | 2,479,173 |           | 0.65 | 
|0.752.5                       |  |                                               | 1,121,393 |                                                 |  | 16.15                                 |  | 1.72                                          |  |                                         | 1,121,393 |           | 1.72 | 
|                               |  |                                               |           |                                                 |  |                                       |  |                                               |  |                                         |           |           |      | 
|                               |  |                                               | 4,383,987 |                                                 |  |                                       |  |                                               |  |                                         |           | 4,383,987 |      |  |  | 
|                               |  |                                               |           |                                                 |  |                                       |  |                                               |  |                                         |           |           |      |  |  | 

F  44

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11  Shareholders Equity (cont.):

|   |            |                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-- | ---------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|C. | Dividends:
|   |            |                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | 1.         | The Company
  has not paid any cash dividends on its ordinary shares in the past and does
  not expect to pay cash dividends on its ordinary shares in the foreseeable
  future.                                                                                                                                                                                                                                                                           
|   |            |                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | 2.         | In the event
  of a distribution of cash dividends out of retained earnings, regarding which
  the Company was tax exempt due to the Approved Enterprise status under the
  Israeli law of encouragement of capital investments, 1959, of its approved
  operations, the Company would have to pay a 25% tax on the said amount. The Company has determined that it will not
  distribute any amounts of its undistributed tax exempt income as dividend.

Note 12 
Monetary Balances in Non-dollar Currency:

|                         |  |                |        |      |   |        |  
|------------------------ |  | -------------- | ------ | ---- | - | ------ | -
|                         |  | December 31,   |       
|                         |  |                |       
|                         |  | 2006           |        | 2005 |  
|                         |  |                |        |      |  
|                         |  | (in thousands) |       
|                         |  |                |       
|                         |  |                |        |      |   |        |  
|ASSETS:                  |  |                |        |      |   |        |  
|Current assets           |  | $              | 12,422 |      | $ | 16,128 |  
|Long-term assets         |  |                | 9      |      |   | 58     |  
|                         |  |                |        |      |   |        |  
|                         |  |                | 12,431 |      |   | 16,186 |  
|                         |  |                |        |      |   |        |  
|LIABILITIES:             |  |                |        |      |   |        |  
|Current liabilities      |  |                | 9,287  |      |   | 11,984 |  
|Long-term liabilities    |  |                | 10,639 |      |   | 4,684  |  
|                         |  |                |        |      |   |        |  
|                         |  |                | 19,926 |      |   | 16,668 |  
|                         |  |                |        |      |   |        |  
|                        
|Net monetary liabilities |  | $              | (7,495 | )    | $ | (482   | )
|                         |  |                |        |      |   |        |  

Note 13  Taxes on Income:

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Tax Benefits Under the Law for the Encouragement of Industry
  (Taxation), 1969:                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | The Company
  currently qualifies as an Industrial Company as defined by this law, and as
  such is entitled to certain tax benefits including, inter alia, depreciation
  at increased rates as stipulated by regulations published under the
  Inflationary Adjustments Law and has the right to deduct for tax purposes,
  over a period of 3 years, expenses relating to public issuance of shares. If
  realized, any tax benefit relating to issuance expenses is credited to
  additional paid-in capital.

F  45

---

---



BLUEPHOENIX
SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13 
Taxes on Income (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Tax Rate Applicable to Income in
  Israel:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | On July 25, 2005, the Law for Amendment of the
  Income Tax Ordinance (Amendment No. 147) became effective. Pursuant to this
  amendment, the income tax applicable to Israeli companies will be gradually
  reduced from 34% in 2005 to 25% in 2010 and henceforth. The regular corporate
  tax In Israel in 2006 is 31%. Deferred Income taxes balances were adjusted accordingly
  and effect of such adjustment was not material. This tax rate decrease is not
  expected to have a material effect on the Companys financial position.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|C. | Deferred Income Taxes:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | Deferred tax assets reflect the net tax effects of
  temporary differences between the carrying amounts of assets or liabilities
  for financial reporting purposes and the amounts used for income tax
  purposes. As of December 31, 2005 and 2006 the Companys deferred taxes were
  in respect of the following:                                                                                                                                                                                                                        

| |                                                                  |  |                |         |      |   |         |  
| | ---------------------------------------------------------------- |  | -------------- | ------- | ---- | - | ------- | -
| |                                                                  |  | December 31,   |        
| |                                                                  |  |                |        
| |                                                                  |  | 2006           |         | 2005 |  
| |                                                                  |  |                |         |      |  
| |                                                                  |  | (in thousands) |        
| |                                                                  |  |                |        
| | Net operating losses carry forwards                              |  | $              | 27,251  |      | $ | 25,034  |  
| | Software development costs                                       |  |                | 1,169   |      |   | 1,566   |  
| | Provisions for employee rights and other temporary
  differences |  |                | 824     |      |   | 735     |  
| |                                                                  |  |                |         |      |   |         |  
| |                                                                  |  |                | 29,244  |      |   | 27,335  |  
| | Valuation allowance                                              |  |                | (29,233 | )    |   | (27,311 | )
| |                                                                  |  |                |         |      |   |         |  
| |                                                                  |  | $              | 11      |      | $ | 24      |  
| |                                                                  |  |                |         |      |   |         |  

|   |                                                                                                                   |                                                                                                                                                                
|-- | ----------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
|   | *                                                                                                                 | The Companys management cannot determine whether it
  is more likely than not that the deferred tax asset relating to net operating
  losses will be realized.
|   |                                                                                                                   |                                                                                                                                                                
|D. | Non-Israeli
  Subsidiaries:                                                                                      
|   |                                                                                                                   |                                                                                                                                                                
|   | Non-Israeli subsidiaries are taxed based upon tax
  laws in the country of domicile of the respective subsidiary.

F  46

---

---



BLUEPHOENIX
SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13
 Taxes on Income (cont.):

|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|-- | ------------------------------------------------------- |  | ----------------------- | ----- | ---- | - | ------ | - | - | ------ | -
|E. | Income before Taxes on Income is
  Composed as Follows:
|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|   |                                                         |  | Year ended December 31, |      
|   |                                                         |  |                         |      
|   |                                                         |  | 2006                    |       | 2005 |   | 2004   |  
|   |                                                         |  |                         |       |      |   |        |  
|   |                                                         |  | (in thousands)          |      
|   |                                                         |  |                         |      
|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|   | Domestic (Israel)                                       |  | $                       | 3,037 |      | $ | (1,560 | ) | $ | (5,097 | )
|   | Foreign                                                 |  |                         | 1,670 |      |   | 3,637  |   |   | 8,792  |  
|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|   |                                                         |  | $                       | 4,707 |      | $ | 2,077  |   | $ | 3,695  |  
|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|F. | Taxes on Income Included in the
  Statements of Income:
|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|   |                                                         |  | Year ended December 31, |      
|   |                                                         |  |                         |      
|   |                                                         |  | 2006                    |       | 2005 |   | 2004   |  
|   |                                                         |  |                         |       |      |   |        |  
|   |                                                         |  | (in thousands)          |      
|   |                                                         |  |                         |      
|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|   | For the reported year - current:                        |  |                         |       |      |   |        |   |   |        |  
|   | Domestic (Israel)                                       |  | $                       | 28    |      | $ | 8      |   | $ | 15     |  
|   | Foreign                                                 |  |                         | 286   |      |   | 164    |   |   | 98     |  
|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|   |                                                         |  |                         | 314   |      |   | 172    |   |   | 113    |  
|   | Taxes related to prior years                            |  |                         | (609  | )    |   | (81    | ) |   | (133   | )
|   | Deferred taxes, net                                     |  |                         | 13    |      |   | 58     |   |   | 280    |  
|   |                                                         |  |                         |       |      |   |        |   |   |        |  
|   |                                                         |  | $                       | (282  | )    | $ | 149    |   | $ | 260    |  
|   |                                                         |  |                         |       |      |   |        |   |   |        |  

F  47

---

---



BLUEPHOENIX
SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13
 Taxes on Income (cont.):

|   |                                                                                                                                                 
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------
|G. | A reconciliation of the theoretical
  tax expense, assuming all income is taxed at the regular rates and the actual
  tax expense is as follows:

|                                                                                                        |  |                |        |      |   |       |   |   |       |  
|------------------------------------------------------------------------------------------------------- |  | -------------- | ------ | ---- | - | ----- | - | - | ----- | -
|                                                                                                        |  | December 31,   |       
|                                                                                                        |  |                |       
|                                                                                                        |  | 2006           |        | 2005 |   | 2004  |  
|                                                                                                        |  |                |        |      |   |       |  
|                                                                                                        |  | (in thousands) |       
|                                                                                                        |  |                |       
|Income before
  taxes on income, per consolidated statements of income                                  |  | $              | 4,707  |      | $ | 2,077 |   | $ | 3,695 |  
|                                                                                                        |  |                |        |      |   |       |   |   |       |  
|Theoretical tax
  expense (35% in 2004, and 34% in 2005 and 31% in 2006)                                |  |                | 1,459  |      |   | 706   |   |   | 1,293 |  
|                                                                                                        |  |                |        |      |   |       |   |   |       |  
|Decrease in
  taxes resulting from permanent differences:                                               |  |                |        |      |   |       |   |   |       |  
|State income
  tax, net of federal benefit                                                              |  |                | (4     | )    |   | (67   | ) |   | 8     |  
|Tax exempt
  income                                                                                     |  |                | -      |      |   | -     |   |   | (246  | )
|Non-deductible
  expenses                                                                               |  |                | 387    |      |   | 282   |   |   | 70    |  
|Effect of
  different tax rates in foreign subsidiaries                                                 |  |                | 407    |      |   | (105  | ) |   | -     |  
|Taxes related to
  previous years                                                                       |  |                | (609   | )    |   | (81   | ) |   | (133  | )
|Carry-forward
  losses and research and development costs for which the Company provided an
  allowance |  |                | (1,922 | )    |   | (649  | ) |   | (432  | )
|Other                                                                                                   |  |                | -      |      |   | 63    |   |   | (300  | )
|                                                                                                        |  |                |        |      |   |       |   |   |       |  
|Taxes on income
  in the consolidated statements of income - for the reported year                      |  | $              | (282   | )    | $ | 149   |   | $ | 260   |  
|                                                                                                        |  |                |        |      |   |       |   |   |       |  
|Effective tax
  rate                                                                                    |  |                | -      |      |   | 7     | % |   | 7     | %
|                                                                                                        |  |                |        |      |   |       |   |   |       |  

|   |                                                                                                                                             
|-- | --------------------------------------------------------------------------------------------------------------------------------------------
|H. | Tax Losses:                                                                                                                                 
|   |                                                                                                                                             
|   | The Company and its subsidiaries in Israel have NOL
  carry forwards for income tax purposes as of December 31, 2006 totaling $52
  million.
|   |                                                                                                                                             
|I. | Tax Assessments:                                                                                                                            
|   |                                                                                                                                             
|   | The Company received final tax assessments in Israel
  through tax year 2002.                                                               

F  48

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 14  Supplementary Financial Statement Information:

|   |                 |                            
|-- | --------------- | ---------------------------
|A. | Balance Sheets:
|   |                 |                            
|   | 1.              | Trade Accounts
Receivables:

|                                       |  |                |        |      |   |        |  
|-------------------------------------- |  | -------------- | ------ | ---- | - | ------ | -
|                                       |  | December 31,   |       
|                                       |  |                |       
|                                       |  | 2006           |        | 2005 |  
|                                       |  |                |        |      |  
|                                       |  | (in thousands) |       
|                                       |  |                |       
|                                      
|Trade accounts receivable              |  | $              | 27,156 |      | $ | 18,824 |  
|Less provision for
  doubtful accounts |  |                | (667   | )    |   | (681   | )
|                                       |  |                |        |      |   |        |  
|                                       |  | $              | 26,489 |      | $ | 18,143 |  
|                                       |  |                |        |      |   |        |  

| |    |                      
| | -- | ---------------------
| | 2. | Other Current Assets:

|                                       |  |                |       |      |   |       | 
|-------------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
|                                       |  | December 31,   |      
|                                       |  |                |      
|                                       |  | 2006           |       | 2005 |  
|                                       |  |                |       |      |  
|                                       |  | (in thousands) |      
|                                       |  |                |      
|Government departments and agencies    |  | $              | 287   |      | $ | 545   | 
|Advances to suppliers and
  others     |  |                | 140   |      |   | 332   | 
|Employees                              |  |                | -     |      |   | 132   | 
|Prepaid expenses                       |  |                | 1,697 |      |   | 1,000 | 
|Related parties                        |  |                | 30    |      |   | 12    | 
|Short-term lease deposits              |  |                | 193   |      |   | 273   | 
|Interest and other income
  receivable |  |                | 749   |      |   | 201   | 
|                                       |  |                |       |      |   |       | 
|                                       |  | $              | 3,096 |      | $ | 2,495 | 
|                                       |  |                |       |      |   |       | 

| |    |                                       
| | -- | --------------------------------------
| | 3. | Accounts Payable and
Accruals  Other:

|                                                 |  |                |       |      |   |       | 
|------------------------------------------------ |  | -------------- | ----- | ---- | - | ----- | 
|                                                 |  | December 31,   |      
|                                                 |  |                |      
|                                                 |  | 2006           |       | 2005 |  
|                                                 |  |                |       |      |  
|                                                 |  | (in thousands) |      
|                                                 |  |                |      
|                                                
|Government departments and
  agencies            |  | $              | 370   |      | $ | 336   | 
|Employees and wage-related
  liabilities         |  |                | 4,994 |      |   | 4,018 | 
|Accrued expenses and other
  current liabilities |  |                | 1,565 |      |   | 2,570 | 
|                                                 |  |                |       |      |   |       | 
|                                                 |  | $              | 6,929 |      | $ | 6,924 | 
|                                                 |  |                |       |      |   |       | 

F  49

---

---



BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 14  Supplementary Financial Statement Information
(cont.):

|   |                          
|-- | -------------------------
|A. | Balance
  Sheets (cont.):
|   |                          

| |    |                                                   |  |                  |        |      |   |        | 
| | -- | ------------------------------------------------- |  | ---------------- | ------ | ---- | - | ------ | 
| | 4. | The
  Companys Long-lived Assets are as Follows: |  |                  |        |      |   |        | 
| |    |                                                   |  |                  |        |      |   |        | 
| |    |                                                   |  | December
  31,   |       
| |    |                                                   |  |                  |       
| |    |                                                   |  | 2006             |        | 2005 |  
| |    |                                                   |  |                  |        |      |  
| |    |                                                   |  | (in
  thousands) |       
| |    |                                                   |  |                  |       
| |    |                                                   |  |                  |        |      |   |        | 
| |    | Israel                                            |  | $                | 24,892 |      | $ | 17,718 | 
| |    | U.S.A.                                            |  |                  | 10,796 |      |   | 9,028  | 
| |    | Europe (other than
  Denmark)                     |  |                  | 1,590  |      |   | 3,118  | 
| |    | Denmark                                           |  |                  | 501    |      |   | 351    | 
| |    |                                                   |  |                  |        |      |   |        | 
| |    |                                                   |  | $                | 37,779 |      | $ | 30,215 | 
| |    |                                                   |  |                  |        |      |   |        | 

|   |                             |                                                                                                                                                                                                                                                                                                                                                                                        
|-- | --------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   |                             | Long-lived assets
  information is based on the physical location of the assets at the end of
  each of the fiscal years.                                                                                                                                                                                                                                                              
|   |                             |                                                                                                                                                                                                                                                                                                                                                                                        
|   |                             | The Company does not
  identify or allocate goodwill by geographic areas.                                                                                                                                                                                                                                                                                                              
|   |                             |                                                                                                                                                                                                                                                                                                                                                                                        
|B. | Statements
  of Operations:
|   |                             |                                                                                                                                                                                                                                                                                                                                                                                        
|   | 1.                          | Geographic
  Areas Information:                                                                                                                                                                                                                                                                                                                                                        
|   |                             |                                                                                                                                                                                                                                                                                                                                                                                        
|   |                             | Sales:
  Classified by Geographic Areas:                                                                                                                                                                                                                                                                                                                                               
|   |                             |                                                                                                                                                                                                                                                                                                                                                                                        
|   |                             | The Company adopted
  Statement of financial Accounting Standard No. 131, Disclosures About
  Segments of an Enterprise and Related Information, (SFAS No. 131). The
  Company operates in one reportable segment (see Note 1 for a brief
  description of the Companys business). the total revenues are attributed to
  geographic areas based on the location of end customers.
|   |                             |                                                                                                                                                                                                                                                                                                                                                                                        
|   |                             | The following present
  total revenues for the years ended December 31, 2004, 2005 and 2006:                                                                                                                                                                                                                                                                                           

| |  |                                                                              |  |                           |        |      |   |        |  |   |        | 
| |  | ---------------------------------------------------------------------------- |  | ------------------------- | ------ | ---- | - | ------ |  | - | ------ | 
| |  |                                                                              |  | Year ended
  December 31, |       
| |  |                                                                              |  |                           |       
| |  |                                                                              |  | 2006                      |        | 2005 |   | 2004   | 
| |  |                                                                              |  |                           |        |      |   |        | 
| |  |                                                                              |  | (in
  thousands)          |       
| |  |                                                                              |  |                           |       
| |  |                                                                              |  |                           |       
| |  | USA                                                                          |  | $                         | 15,048 |      | $ | 17,423 |  | $ | 20,438 | 
| |  | Europe (other than
  Denmark)                                                |  |                           | 28,449 |      |   | 18,643 |  |   | 15,860 | 
| |  | Denmark                                                                      |  |                           | 10,304 |      |   | 12,334 |  |   | 10,122 | 
| |  | Israel                                                                       |  |                           | 10,156 |      |   | 7,991  |  |   | 8,353  | 
| |  | Other                                                                        |  |                           | 4,047  |      |   | 2,556  |  |   | 2,413  | 
| |  |                                                                              |  |                           |        |      |   |        |  |   |        | 
| |  |                                                                              |  | $                         | 68,004 |      | $ | 58,947 |  | $ | 57,186 | 
| |  |                                                                              |  |                           |        |      |   |        |  |   |        | 
| |  |                                                                              |  |                           |        |      |   |        |  |   |        | 
| |  | Sales by
  geographic areas are determined based on the customers location. | 

F  50

---

---



BLUEPHOENIX SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                                   |                                     |                                                     
|------------------------------------------------------------------ | ----------------------------------- | ----------------------------------------------------
|Note 14  Supplementary
  Financial Statement Information (cont.):
|                                                                   |                                    
|B.                                                                 | Statements
  of Operations (cont.):
|                                                                   |                                    
|                                                                   | 2.                                  | Principal
  Customers:                              
|                                                                   |                                    
|                                                                   |                                     | Major customer over 10% of
  the Companys revenues:

|           |  |      |   |      |    |      |  |    |   |  | 
|---------- |  | ---- | - | ---- | -- | ---- |  | -- | - |  | 
|           |  | 2006 |   | 2005 |    | 2004 |  |   
|           |  |      |   |      |    |      |  |   
|           |  |      |   |      |    |      |  |    |   |  | 
|Customer A |  | 11   | % |      | 17 | %    |  | 15 | % |  | 
|Customer B |  | 15   | % |      | -  |      |  | -  |   |  | 

| |    |                         
| | -- | ------------------------
| | 3. | Financial Expenses, Net:

|                                                                         |  |                         |        |      |   |        |   |   |      |  
|------------------------------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ | - | - | ---- | -
|                                                                         |  | Year ended December 31, |       
|                                                                         |  |                         |       
|                                                                         |  | 2006                    |        | 2005 |   | 2004   |  
|                                                                         |  |                         |        |      |   |        |  
|                                                                         |  | (in thousands)          |       
|                                                                         |  |                         |       
|Interest income                                                          |  | $                       | 237    |      | $ | 191    |   | $ | 205  |  
|Foreign currency translation adjustments (see Note 1A4)                  |  |                         | (50    | )    |   | (580   | ) |   | 69   |  
|Interest expense                                                         |  |                         | (1,117 | )    |   | (898   | ) |   | (632 | )
|Debentures and convertible debt financial
  expenses                     |  |                         | (2,981 | )    |   | (938   | ) |   | (688 | )
|Income from derivative financial
  instruments and marketable securities |  |                         | 396    |      |   | 247    |   |   | 164  |  
|                                                                         |  |                         |        |      |   |        |   |   |      |  
|                                                                         |  | $                       | (3,515 | )    | $ | (1,978 | ) | $ | (882 | )
|                                                                         |  |                         |        |      |   |        |   |   |      |  

| |    |                                      
| | -- | -------------------------------------
| | 4. | Gain on Realization of Shareholdings:

|       |  |                         |   |      |   |      |  |   |     |  
|------ |  | ----------------------- | - | ---- | - | ---- |  | - | --- | -
|       |  | Year ended December 31, |  
|       |  |                         |  
|       |  | 2006                    |   | 2005 |   | 2004 | 
|       |  |                         |   |      |   |      | 
|       |  | (in thousands)          |  
|       |  |                         |  
|Cicero |  | $                       | - |      | $ | -    |  | $ | 171 |  
|Other  |  |                         | - |      |   | -    |  |   | (59 | )
|       |  |                         |   |      |   |      |  |   |     |  
|       |  | $                       | - |      | $ | -    |  | $ | 112 |  
|       |  |                         |   |      |   |      |  |   |     |  

| |    |                     
| | -- | --------------------
| | 5. | Other
  Income, Net:

|                                                |  |                         |     |      |   |      |  |   |     |  
|----------------------------------------------- |  | ----------------------- | --- | ---- | - | ---- |  | - | --- | -
|                                                |  | Year ended December 31, |    
|                                                |  |                         |    
|                                                |  | 2006                    |     | 2005 |   | 2004 | 
|                                                |  |                         |     |      |   |      | 
|                                                |  | (in thousands)          |    
|                                                |  |                         |    
|Gain (loss) on sale of
  property and equipment |  | $                       | -   |      | $ | 35   |  | $ | (14 | )
|Dividend income (*)                             |  |                         | 282 |      |   | -    |  |   | 703 |  
|Other                                           |  |                         | -   |      |   | 69   |  |   | 286 |  
|                                                |  |                         |     |      |   |      |  |   |     |  
|                                                |  | $                       | 282 |      | $ | 104  |  | $ | 975 |  
|                                                |  |                         |     |      |   |      |  |   |     |  

| |     |                                                                                                                                                                                       
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (*) | Dividend income from Steps
  Ventures, An Israeli venture capital investment group, in which the Company
  holds 375,000 shares representing 3.75% of their outstanding share capital.

F  51

---

---



BLUEPHOENIX SOLUTIONS LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                                   |                                                                                                                                                                                                                                                                                                                                                                           | 
|------------------------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|Note 14  Supplementary
  Financial Statement Information (cont.):
|                                                                   |                                                                                                                                                                                                                                                                                                                                                                           | 
|C.                                                                 | Earnings Per Share:                                                                                                                                                                                                                                                                                                                                                      
|                                                                   |                                                                                                                                                                                                                                                                                                                                                                           | 
|                                                                   | Basic earnings per share
  (EPS) was computed based on the average number of shares outstanding during
  each year, after giving retroactive effect to stock dividends and stock
  splits. In computing diluted EPS, effect was given to share options
  outstanding in each period, using the treasury stock method, provided that
  such effect is not anti-dilutive.
|                                                                   |                                                                                                                                                                                                                                                                                                                                                                           | 
|                                                                   | The following table sets
  forth the computation of basic and diluted net earnings per share.                                                                                                                                                                                                                                                                            

|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|-- | ---------------------------------------------------------------------------------------------------------- |  | ----------------------- | ---------- | ---- | - | ---------- |  | - | ---------- | 
|   |                                                                                                            |  | Year ended December 31, |           
|   |                                                                                                            |  |                         |           
|   |                                                                                                            |  | 2006                    |            | 2005 |   | 2004       | 
|   |                                                                                                            |  |                         |            |      |   |            | 
|   |                                                                                                            |  | (in thousands)          |           
|   |                                                                                                            |  |                         |           
|1. | Numerator:                                                                                                 |  |                         |            |      |   |            |  |   |            | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   | Amount for basic earning per share  income available to
shareholders                                      |  | $                       | 4,672      |      | $ | 1,789      |  | $ | 2,846      | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   | Effect of dilutive securities                                                                              |  |                         | -          |      |   | -          |  |   | 276        | 
|  
|   | Amount for diluted earnings per share  income available to
  shareholders                                 |  |                         | 4,672      |      |   | 1,789      |  |   | 3,122      | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|2. | Denominator:                                                                                               |  |                         |            |      |   |            |  |   |            | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   | Denominator for basic net earnings per share - weighted average of
  shares                                |  |                         | 13,889,483 |      |   | 13,556,627 |  |   | 13,522,866 | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|  
|   | Effect of dilutive securities:                                                                             |  |                         |            |      |   |            |  |   |            | 
|  
|   | Employee share options                                                                                     |  |                         | 481,421    |      |   | 403,382    |  |   | 477,713    | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   | Dilutive effect of issued debentures                                                                       |  |                         | -          |      |   | -          |  |   | 678,447    | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   | Potential dilutive ordinary shares                                                                         |  |                         | 481,421    |      |   | 403,382    |  |   | 1,156,160  | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   | Denominator for diluted net earnings per share - weighted average
  shares and assumed exercise of options |  |                         | 14,370,904 |      |   | 13,959,909 |  |   | 14,679,026 | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   | Basic net earnings per share                                                                               |  | $                       | 0.34       |      | $ | 0.13       |  | $ | 0.21       | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|   | Diluted net earnings per share                                                                             |  | $                       | 0.33       |      | $ | 0.13       |  | $ | 0.21       | 
|   |                                                                                                            |  |                         |            |      |   |            |  |   |            | 

| |                                                                                                                                                                                                                                                                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Employees share options
  and warrants issued to purchase 1,315,935, 1,677,609 and 1,318,817 shares at
  various prices between $4.5 and $10.5 per share were outstanding during the
  years of 2006, 2005, and 2004, respectively, but were not included in the
  computation of diluted EPS because the options exercise price was higher than
  the average market price of the ordinary shares.
| |                                                                                                                                                                                                                                                                                                                                                                                                     
| | 715,649 and
  3,048,930 shares underlying the convertible debentures and notes were
  excluded from the computation of diluted EPS in 2006 and 2005 respectively,
  since their inclusion would have had an anti-dilutive effect on EPS.                                                                                                                                                            

F  52

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BLUEPHOENIX SOLUTIONS LTD.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 15  Transactions with Related Parties:

|                                                            |                                                                                           |  |                         |       |      |   |       |  |   |       | 
|----------------------------------------------------------- | ----------------------------------------------------------------------------------------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | ----- | 
|                                                            |                                                                                           |  | Year ended December 31, |      
|                                                            |                                                                                           |  |                         |      
|                                                            |                                                                                           |  | 2006                    |       | 2005 |   | 2004  | 
|                                                            |                                                                                           |  |                         |       |      |   |       | 
|                                                            |                                                                                           |  | (in thousands)          |      
|                                                            |                                                                                           |  |                         |      
|Formula,
  its subsidiaries and other associated companies: |                                                                                           |  |                         |       |      |   |       |  |   |      
|                                                            |                                                                                           |  |                         |       |      |   |       |  |   |       | 
|A.                                                          | Selling, general and
  administrative expenses: 
  management fees (Note 10A1)            |  | $                       | 180   |      | $ | 180   |  | $ | 180   | 
|                                                            |                                                                                           |  |                         |       |      |   |       |  |   |       | 
|B.                                                          | Revenues from sale of
  software conversion tool and software services to related parties |  | $                       | 1,214 |      | $ | 1,694 |  | $ | 1,973 | 
|                                                            |                                                                                           |  |                         |       |      |   |       |  |   |       | 
|C.                                                          | Cost of revenues relating
  to services from related parties                              |  | $                       | 1,217 |      | $ | 1,761 |  | $ | 2,315 | 
|                                                            |                                                                                           |  |                         |       |      |   |       |  |   |       | 
|D.                                                          | Reimbursement related to
  services rendered to affiliated and other companies            |  | $                       | 43    |      | $ | 41    |  | $ | 235   | 

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|E. | Arie Kilman was nominated
  as the Companys Chief Executive Office in May 2003. In his former position
  as Lirazs chairman of the board of directors, he was granted by Liraz in May
  2002 a loan in an amount equal to approximately $300 thousand, linked to the Israeli
  Consumer Price Index, and bearing annual interest at a rate of 4%. Under the
  terms of the loan, the loan was repaid to Liraz in four equal annual
  installments, the last one of which was made in 2006.  Mr. Kilman has fully complied with all
  loan payment obligations under the loan agreement.                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|G. | In January 2006, the
  company entered into a services agreement with TIS Ltd., (TIS), a Cypriot
  company. Under the agreement, TIS provided the Company with consulting and
  other professional services. When the Company signed the agreement with TIS,
  38.8% of the share capital of TIS was held by CTI Ltd., (CTI), a Cypriot
  company. Mr. Kilman, the Companys chief executive officer and director holds
  49% interest in CTI. Therefore, the transaction was considered as a related
  party transaction and the company obtained the necessary approvals required
  under Israeli law. In November 2006, Mr. Kilman notified the company that CTI
  sold the shares it held in TIS and it was no longer a shareholder of TIS. In
  2006, the company paid fees to TIS in an aggregate amount of $300 thousand.

Note 16  Subsequent Events:

In 2007 first quarter, several
investors converted $1.2 million principal amount of debentures issued in March
2004 into 229,008 ordinary shares, and $2.0 million principal amount of
debentures issued in March 2006 into 443,334 of the Companys ordinary shares
(see also Note 11B2).

F  53

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